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Do Central Banks prop up equity prices?

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Cullen has mentioned several times that QE is just an asset swap between the Central banks and Private sector banks, and there is no net new money injected into the system. So is the current 9 year long bull market and housing bubble 2.0 (since 2008) entirely psychological and investors just buy into the story that “Central Banks are propping up the markets?” Or is this rise based on strong underlying economic fundamentals?

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Posted by Incognito 7
Posted on 05/11/2017 12:23 PM
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This is like asking if a stock buyback props up equity prices? Think of it. It’s the same basic mechanism. When a company buys back stock they are engaging in an asset swap of sorts – they are reducing the share count by spending some of their cash into the economy. This reduces outstanding shares and potentially boosts EPS. The current owners are better off in that they own a greater % of the same amount of free cash flow. BUT, the real question is, even though the owners are better off we have to ask ourselves if the company is better off? Well, it depends. If the buyback is done when the stock is operating above capacity (it’s overvalued) then the buyback will be bad. If the buyback is done when the stock is operating below capacity (it’s undervalued) then this might be a good use of free cash flow.

Same basic premise works for QE. When QE was implemented in 2009 the Fed was issuing cash in exchange for bonds in an event that helped shore up the financial system. We were operating well below capacity and so QE was helpful. The impact was lessened as the economy improved. But it’s the same basic idea. QE or stock buybacks are not necessarily good or bad. It just depends on when you implement them. But what really matters for the health of the economy and corporations is not how much the govt or the board of directors tries to prop up prices, but how well the underlying fundamentals of the entities actually change over time. And that just comes from good old hard work and innovation. Not financial engineering.

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Cullen Roche Posted by Cullen Roche
Answered on 05/11/2017 12:40 PM
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    Just a clarification: You’ve mentioned that Banks swapped their bonds for cash from the Fed during QE.

    Does this assume Banks have a preexisting supply of bonds ready to exchange for cash at any given time?

    What if Banks didn’t have any bonds? Would they have been screwed i.e. Lehman Bros?

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    Posted by Incognito 7
    Answered on 05/11/2017 12:54 PM
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      Banks are mostly just acting as intermediaries here. They’re buying from households and institutions and then selling to the Fed.

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      Cullen Roche Posted by Cullen Roche
      Answered on 05/11/2017 12:56 PM
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        Equity prices are highly valued due to low interest rates, which drives up asset prices by driving down discount factors. As the Fed starts tightening, discount factors will rise, but I don’t see the US having high interest rates for a very long time.

        If you take out the period from 1965-1995, the US 10 year never reached above ~6-7%. So from a historical standpoint, US interest rates are much more in line with historical averages today than they were in the period most older people are accustomed to thinking (I’m 25, so I don’t have that worldview). In other words, this is much closer to normal than the ~1965-1995 period which was truly abnormal.

        Keep in mind that much of these gains are coming from a few specific stocks (namely firms like Facebook, Amazon, Apple, Netflix, Google, etc). Outside of those specific firms, most firms aren’t overvalued and there’s plenty of value in the market if you know where to look.

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        Posted by Suvy Boyina
        Answered on 05/13/2017 12:06 PM
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          Equity prices are highly valued due to low interest rates, which drives up asset prices by driving down discount factors. As the Fed starts tightening, discount factors will rise, but I don’t see the US having high interest rates for a very long time.

          If you take out the period from 1965-1995, the US 10 year never reached above ~6-7%. So from a historical standpoint, US interest rates are much more in line with historical averages today than they were in the period most older people are accustomed to thinking (I’m 25, so I don’t have that worldview). In other words, this is much closer to normal than the ~1965-1995 period which was truly abnormal.

          Keep in mind that much of these gains are coming from a few specific stocks (namely firms like Facebook, Amazon, Apple, Netflix, Google, etc). Outside of those specific firms, most firms aren’t overvalued and there’s plenty of value in the market if you know where to look.

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          Posted by Suvy Boyina
          Answered on 05/13/2017 12:06 PM
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