Broker Check

The Federal Reserve and Financial Markets

Our world has experienced a wild ride as of late 

  • December of 2019 - A wildfire destroyed 20 million acres of land in Australia. [10]
  • January of 2020 – First global pandemic in world history to affect every nation.
  • February 5 – A U.S. president was nearly impeached for the 3rd time in U.S. history. [11]
  • March of 2020 – One of the fastest stock market crashes in U.S. history. [12]
  • March of 2020 - Nationwide shortage of toilet paper. [13]
  • March of 2020 - Much of the world’s population was locked down for the first time in world history. [14]
  • April of 2020 – The Pentagon officially released videos allegedly showing military interactions with UFOs. [15]
  • April of 2020 - Oil prices fell to $0 for the first time in world history. [16]
  • April of 2020 – U.S. unemployment reached its highest level since the Great Depression. [17]
  • May of 2020 - Murder hornets were found in the U.S. for the first time in history. [18]
  • June of 2020 - Thousands of protests, riots, and looting spread across the nation in 2020. [19]
  • August of 2020 -  Beirut suffered from one of the largest explosions in world history. [20]
  • August of 2020 - 5 million acres burned along the West coast of our country. [21]
  • September of 2020 - Home schooling doubled in our country. [22]
  • October of 2020 – U.S national debt reached $27 trillion, up from $5.8 trillion in 2000. [23]
  • November of 2020 - Two presidential contenders each received the highest number of votes in U.S. history.[24]
  • December of 2020 – Many Americans received government stimulus checks [25] and rent relief [26] for the first time in their lives.
  • December of 2020 – Most of the world wore a mask in public for the first time in world history. [27]
  • January of 2020 - A U.S. Capital building was invaded for the first time since 1812. [28]
  • February of 2021 – A polar vortex caused every U.S. state to have sub-freezing temperatures on the same day. [29] 

The stock market should not have performed well during such a volatile time in our world's history. Nevertheless, the stock market reached historical highs again and again throughout the second half of 2020. This was likely caused by various monetary policies instituted by the Federal Reserve (the Fed) as well as the many stimulus packages passed by Congress. In fact, we believe that the Fed's policies have been helping stocks and hurting bonds for quite some time now.

Fed policies are helping stocks and hurting bonds

Prior to 2008, bonds were a great tool for investing whenever the stock market performed poorly. Bonds historically held less inherent risk than stocks and paid a decent interest rate to investors. This is why most moderate risk investors have historically invested about 40% to 50% of their portfolio in bonds.

After 2008, the Federal Reserve (the Fed) attempted to stimulate the economy by lowering interest rates to nearly 0%. Since then, bonds have had a difficult time providing a decent return to investors. This has caused many investors to replace their bond investments with riskier stock investments. This stock-heavy investment strategy is one of the reasons the stock market has skyrocketed far beyond the bond market since 2008[1].


The stock market no longer reflects the reality of our economy

The stock market is meant to reflect how investors feel about the economy. Therefore, the stock market should mirror what we see happening in the economy. If the economy is doing poorly, then the stock market should be falling. If the economy is improving, then the stock market should be increasing.

Instances such as what we are facing now show that the stock market can get ahead of itself by outpacing the value of our economy. This overvaluation of our stock market cannot last forever. Either the economy must catch up with the stock market or the stock market will eventually fall back down to reality.

Below is a chart which provides the ratio of the Wilshire 5000 to Gross Domestic Product (the “ratio”).[2] The higher the ratio is, the higher the value our country’s stock market is in relation to its economy. Therefore, a higher ratio means that the stock market is increasingly out of touch with the reality of the economy. This ratio was relatively high in both 2000 and 2007 shortly before the U.S. stock market experienced two major downturns. The Wilshire 5000 to GDP ratio is currently about 2 to 1 which is significantly higher than it was in 2000 or 2007.

Even so, the stock market might keep climbing for some time to come

Such a high ratio would normally be concerning. However, we are not experiencing a normal situation. The Fed’s policies are causing investors to place an abnormal amount of their money into stocks. Such a high ratio may therefore be justified until the Fed alters its policies to make bonds an attractive investment once again.[3] This may continue for the foreseeable future as the Fed intends to keep interest rates low through at least 2023.[4], [5]

Fed polices might help the stock market, but they don’t prevent market crashes

It is true that the stock market may continue to rise for as long as the Fed maintains its policies of low interest rates and easy money. Nevertheless, we must keep in mind that the stock market is significantly more volatile than the bond market. In fact, the frequency of major U.S. stock market crashes has steadily increased over time. Below is a list of the largest U.S. stock market crashes as well as the percentage drop which our stock market experienced at that time.[6], [7]

  • 1929 - 84%
  • 1973 - 42%
  • 1987 - 30%
  • 1999 - 45%
  • 2008 - 51%
  • 2020 - 35%

Some blame this on high frequency trading, others on 24 hour news coverage, and still others on various monetary and economic policies taken on by our government. No matter what the case may be, investors need to be aware that the stock market is inherently more risky than the bond market. This is why stocks often offer a greater long-term return on investment than bonds.

Bonds can have a bad day too

Bonds are often less volatile than stocks, but bonds can experience a bad day as well. Take for example the fact that the bond market (VBTLX) lost value earlier this year while the stock market (VTSAX) continued to rise upwards. This was likely because interest rates rose on 10 year Treasuries for the first time in a while. [8]

Rising interest rates can hurt bond-holding moderate risk investors

The falling bond market likely hurt the performance of many moderate risk investment portfolios which tend to be heavily invested in bonds. This is because rising interest rates can temporarily lower the value of bond investments.[9] For instance, let’s assume that your portfolio held bond investments which offered an interest rate of 1% on a day when interest rates rose to 2%. New bond investments would then offer a 2% interest rate to investors which would be significantly higher than the 1% interest rate offered by the bonds you own. As a result, your bonds would now sell for less because they offer a lower return on investment than newer bonds.

There is no crystal ball

It seems as though the stock market may continue its upward trend for a while longer. However, 2020 has shown us that future events are unpredictable at best. Any number of scenarios, including another Covid strain or outbreak, could send the stock market in the opposite direction. Only time will tell. What we can do is keep a cool head when it seems as though the world has gone crazy. This strategy served us well in 2020 when we heard about UFOs, murder hornets, and the umpteenth riot. It may serve us well again. 



[2] The Wilshire 5000 is an index which is meant to represent the U.S. stock market. GDP is the Gross Domestic Product of the United States. The Wilshire 5000 and GDP provide us with a broad overview of how our country’s stock market and economy, respectively, have performed throughout history.