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The Federal Reserve, the facade of which is pictured, has been a key factor in QE

QE & Adventures in a Fed-Driven Market: 2020 Market Recap and 2021 Outlook

Feb 2, 2021 | Market Commentary

Technically, the record-breaking bull market that started in 2009 ended in 2020. I say “technically” because the sell-off was so short-lived that it almost didn’t feel like a true bear market, and the rebound was so sharp that it didn’t feel like a proper recovery. As we continue to emerge from the Q1 shock, our new bull market sure feels a lot like the continuation of the previous decade-long uptrend, with the same drivers (low rates, central bank intervention) and the same dominant sectors (with big tech leading the way). 

Last year’s events left many investors with a feeling of unease at the disconnect between the economy and the market. Many were already skeptical about valuations prior to COVID. When a brief collapse was immediately followed by a moon-shot to unthinkable new highs, investor skepticism rose along with it. This is perhaps the most common point of concern for our clients: how can weak economies, with falling demand and rising unemployment, justify higher equity prices? When faced with this question, I’ve often tried to draw our clients’ attention to the prodigious scale of the monetary measures being implemented, and to the fact that the link between markets and the economy isn’t always as direct and linear as many investors expect, as we will discuss later. 

One way or another, it’s largely been about the Federal Reserve and their international counterparts (ECB, BOJ…), and while 2020 will probably be remembered as the year when everything changed, as far as markets are concerned, we seem to be trapped in the same powerful dynamics that were in place a year ago, and which have become even more deeply entrenched as a result of the pandemic.

Fun With Trillions

At the beginning of 2020, many observers would have described global monetary policy as extremely loose, historically so. Part of the bearish narrative was that central banks had run out of ammunition: with both ECB and Federal Reserve balance sheets hovering around all-time highs, and interest rates near zero, surely there wasn’t much left for central banks to do. 

As it turns out, they were just warming up. 

Keeping up with monetary policy and high-flying government finance requires a rare skill: the ability to make sense of large — very large — numbers. Can anyone really wrap their minds around numbers like 665,900,000,000,000 — or 666.9 trillion — the approximate size of the Bank of Japan’s balance sheet in Yen? 

Central bankers and politicians seem to deal only in rounded trillions nowadays: the first COVID relief bill was 2 trillion dollars, the ECB expanded its Quantitative Easing (QE) program in June by 1.3 trillion Euros, and so on…and with every new trillion-dollar headline, the world of big finance grows increasingly disconnected from reality, almost like it exists in its own parallel universe. 

Trying to relate the idea of trillions of dollars to something tangible would look something like this: if you had 1 million dollars in a compact stack of 1,000 dollar bills, the stack would be approximately 4 inches in height. A million is a lot of money by any standard, yet it’s small enough to carry in a handbag. To get to a billion dollars, the stack of 1,000 dollar bills would have to grow to about 358 feet, or about 50 feet higher than the Statue of Liberty. To get to a trillion, the stack would need to grow to a length of approximately 67.9 miles. (1)

Central bankers don’t need to worry about the logistics involved in printing and shipping 70-mile long stacks of bills, they save themselves the hassle by creating currencies in electronic form, but the impact on markets of their various trillion-dollar endeavors are just as real. 

To understand why 2020 was truly the year of “Fun with Trillions”, consider the following chart:

The main global central banks have added nearly 8 trillion dollars to their combined balance sheet in 2020 alone. Source: Atlantic Council global QE tracker

The Federal Reserve added 3.2 trillion dollars to its balance sheet in 2020 alone, more than it did in the entire 2009 to 2019 period. Source:

Over 20% of the U.S. money supply (measured a Money of Zero Maturity) was created in 2020 alone. Source:

So what does this all mean? Therein lies the issue for investors — we can observe trillions of dollars being (digitally) printed and hear about it on the news, but what does it mean for markets? How does that relate to the size of our 401k’s? Or Apple’s share price? What would today’s markets look like if QE had never existed?

One team of analysts at Société Générale did attempt to answer this thorny question. (2) Sophie Huynh and Charles De Boissezon, of the bank’s equity research group, used a regression analysis to estimate the impact of QE on treasury yield. They estimate it at about 180 basis points cumulatively since 2009 (in other words, without QE the 10-year yield would be close to 3%). They then used a dividend discount valuation model and the bank’s proprietary model for equity risk premiums (the excess return of equities of bonds) to derive a hypothetical valuation of stocks without QE. 

Their results are rather striking.

As shown above, the impact on stocks’ prices has been dramatic according to their model and even more pronounced in the NASDAQ than the S&P 500.

Overall, the bank’s model estimates that 44% of today’s S&P 500’s price level can be attributed to QE. In the tech-heavy NASDAQ, the percentage rises to 57%. The pace of change has not been linear, and 2020 saw a massive spike in the percentage of price level explained by QE.

We’ll never know how accurate this model truly is, but I believe it captures one fundamental truth about current market conditions, which is simply that QE changes everything. 

With the 10-year yield over 3%, and the S&P 500 at 2000, markets would certainly not be as exciting as they are today, but some might say that they would be a more honest reflection of the economy.

The eternal bullishness of a stagnant economy 

Whatever QE’s impact on the market might have been, it’s unclear whether it has benefited the economy in any meaningful, lasting ways. The pace of U.S. economic growth has generally been around 2% for nearly a decade until 2020.

Early forecasts indicate a decline in U.S. GDP of around 3.5% in 2020, though it’s expected to rebound in 2021. Meanwhile, corporate earnings have barely grown in the last few years, even as markets soared to all-time highs.

This environment of stagnant economies and earnings growth has prompted many to speculate that markets have risen too far, too fast, and these concerns are valid. After all, QE or not, one would expect economic realities to eventually catch up with markets. All else equal, slowing earnings growth should result in lower stock prices. With that being said, we must also keep in mind that the market and the economy are two distinct entities.

In a recent research piece, Vincent Deluard (StoneX’s head of macro research) makes a simple yet counter-intuitive point which I think helps capture a lot of today’s market dynamics. His view can be summarized as follows: in an environment of secular stagnation, where discount rates and growth decline, stock prices will soar. To understand his point, it helps to review some very basic concepts of equity valuation. 

Stocks are ultimately just claims on a future stream of cash flow, a dividend for example, or whatever might correspond to the liquidation value of a company. Any stream of future cash flow is valued by dividing the periodic cash flow by a discount rate, which accounts for the time value of money, and for risk. For example, a hypothetical annual payment of 10 dollars that lasts forever would be valued by simply dividing 10 by 5% (if we assumed a 5% discount rate): 10 / 0.05 = 200, so this perpetual cash flow of $10/year is worth $200 dollars today.

Equity valuation works in a very similar way, but the discount factor is slightly more elaborate. One example of a basic stock valuation model is the Gordon Growth Model, which works with the formula on the left.

This is conceptually very similar to our perpetual annuity example. The discount rate “r” can be thought of as the rate of return that investors require for the stock, the constant cost of equity capital. Because company earnings grow over time, “g” is added to account for growth, and reduces the discount rate, causing the value of the ratio to increase (the stock price to rise).

Going back to our example, imagine a company (let’s call it Stagnant Inc.) that pays a $10 annual dividend per share. Stagnant Inc’s share price could be valued as follows using the Gordon Growth Model:

10 / (0.10 – 0.5) = $200

In the above example, 0.10, or 10% is the “r”, the discount rate, the return investors expect, and 0.05 is the 5% growth of the company’s dividend. If we assume that Stagnant Inc.’s growth rate declines by 10% a year going forward, and that the expected rate of return “r” also declines by the same 10%, the stocks price over a 50 year period would like this:

In 50 years, Stagnant Inc.’s stock price soared from $200 to over $34,000, a gain of over 11% a year, all happening despite a steady decline in earnings growth. This is what Vincent Deluard refers to as “the crazy math of secular stagnation.” (3)

Source: Vincent Deluard, StoneX research,

As shown above, lower capital costs (discount rate) can justify higher valuations even in the face of dwindling earnings growth. As both growth and discount rates trend towards zero, prices rise to infinity.

This is perhaps what many investors have missed when constantly expecting markets to fall back to earth: while there truly is a disconnect between the economy and markets, there may also exist a causal link between economic weakness and higher stock prices, a self-reinforcing trend of perverse incentives where slow growth fuels market uptrend, where bad news for the economy can quite literally become good news for stocks, and markets may have been riding this stagnation boom for many years now. 

I would add that QE and central bank interventions are factors that will tend to affect expected returns over time. In markets, the cost of equity capital is mainly a function of interest rates, volatility, and risk premia. By keeping interest rates low and dampening volatility, central banks’ activity can really be thought of as one giant exercise in reducing expected returns. When the Federal Reserve announced that it would start buying high yield bond ETFs, the prices of these bonds quickly jumped. There is nothing irrational about this investor behavior. If a high yield bond had a yield of 6% prior to the Federal Reserve’s decision to step in, once the Fed enters the fray, investors were happy to accept a lower yield, maybe 5%, simply because they knew the Fed would step in to support prices as needed. Equities work the same way. In a world where any weakness or volatility is met with the immediate expansion of the Fed’s balance sheet and trillions in government intervention, you would expect equity investors to feel more comfortable and adjust their risk appetite. For example, a stock that an investor would have normally considered too risky to buy (perhaps a high-octane IPO), can suddenly become a very justifiable acquisition once the Fed’s de-facto pledge to support markets is factored in. Coincidentally, more IPOs have doubled in price in 2020 than any year since the tech bubble. (4)

This reasoning can be pushed even further to explain some of the current sector dynamics: in a world of constantly falling cost of capital, equity valuation becomes disproportionately affected by cash flow duration. To draw a parallel from the bond world, if we knew that rates were going to consistently decline, we would naturally look to buy the longest-dated bonds (maybe a 20+ year treasury). Likewise, if the equity cost of capital is constantly falling, winning the equity valuation race becomes a game of who can extend cash flow duration the furthest into the future. 

This may at least partially explain why today’s dominant stocks are to be found in the tech world. As highlighted in StoneX’s report, U.S. tech giants, with their low payout ratios, low book values, and future-proof product lines, can be thought of as the equity equivalent of a very long-dated bond and will benefit the most from the falling cost of capital. The SocGen report referenced earlier also highlighted that the tech sector’s outsized benefit from QE for similar reasons. 

In the game of ever-increasing cash flow duration, current earnings and profitability are secondary to future cash flows. Any company with a semblance of growth enters the race to a near zero-value denominator and is disproportionately favored by investors. Similarly to how aggressive bond traders might look to increase the convexity of their books (buy bonds with the highest duration sensitivity to changes in yield), equity traders could be chasing stocks with the greatest pace of price appreciation for a given decline in capital cost, endlessly bidding up speculative growers in the tech world, at the expense of value and yield. 

These ideas would certainly be consistent with what we witness almost daily in today’s market, which appears to be obsessed not just with innovation, but with all manners of futuristic buzzwords. In today’s world, computing is not enough, you need quantum computing, automation is not enough, you need AI, databases are not enough, you need blockchain, trucks are not enough, we demand cybertrucks.

But of all the tech-obsessed endeavors, my favorite is probably space exploration. When it comes to creating the longest cash flow duration imaginable, I can’t think of anything better than spending the next few decades burning through trillions of dollars building spaceships, all in the hope of one day dominating the intergalactic travel market. So it is perhaps no surprise that just about every billionaire CEO seems in love with the idea: Elon Musk has SpaceX, Richard Branson has Virgin Galactic, Jeff Bezos has Blue Origin. In a day and age when life on earth seemingly requires a constant supply of face masks, antiseptic wipes, and experimental vaccines, perhaps the time has come for us to propel ourselves into outer space in search of less green pastures. After all, life in one of Elon Musk’s planned human colonies on Mars can’t be all that much different from being locked down in a Berlin suburb. (5)


In his book “The Systems Bible” John Gall introduces a concept he calls “operational fallacy”, which describes instances where systems do not do what they say they do. The best way to explain operational fallacy is to think of a simple term like “fresh apples.” Fresh apples can evoke the thought of strolling through your grandmother’s garden on a late summer day, and picking ripe apples right off the tree, perhaps to make a delicious pie later that day. But “fresh apples” could also be an item you grab from the shelf of a suburban supermarket while quickly pushing your cart down the produce aisle one evening after work. In both examples, the term “fresh apples” is technically correct, yet the two products and experiences are nothing alike. What most people really want is grandma’s apple experience, but that’s exactly what the system cannot provide.

2020’s pandemic and the ongoing economic struggles of the last decades have prompted leaders around the world to implement a variety of support measures to stimulate the economy. Those same decision-makers would no doubt congratulate themselves on what they perceive to have been decisive and successful steps that secured the economy, fostered growth, and protected the integrity of markets through difficult times. Yet the results produced by this complex system of incentives hardly match what most would look for in a prosperous economy. The economic equivalent of grandma’s apple would probably involve a combination of plentiful well-paying local jobs, healthy government finances, and growth. Instead, the current economic landscape delivered stagnant growth, gig-economy, and soaring deficits. 

Perhaps these support measures are more likely to produce supermarket apples: the mechanism through which quantitative easing (by far the largest component of all stimulus attempts) benefits the economy is still unclear, and one could argue that QE is in fact counterproductive. Instead of promoting growth, easy money and low rates may instead lead to misallocation of capital, leading to weaker economies and fueling the vicious cycle of stagnation. 

What these measures did achieve was a spectacular rally in stock price, and this may be because QE is more akin to a form of price control than an economic stimulus. Historically, price control has involved various attempts to reduce the price of goods to curb inflationary forces, but we have no need for that type of price control now. In today’s upside-down, hyper-financialized world, we’re instead attempting to generate growth and inflation by controlling the price of risk, the cost of financial capital. Global markets are supposed to be way too large to be controlled by anyone, but trillions of dollars have a way of coercing even the strongest forces of their will. 

Attempts at price control generally have a terrible historical track record, and while I spent a lot of time justifying the market‘s continued rise in my comments, it’s important to note that the same market dynamics can work just as efficiently in the opposite direction to produce sharp sell-offs and volatility.  This may be the greatest challenge our decision-makers will face: how to navigate our way out of the current QE-fueled trap, and back to healthier market dynamics?  

Eventually, market forces always prevail against attempts to control them. Everything has a price, and even if the current trends remain in place for the foreseeable future, sooner or later, the law of unforeseen consequences will cause distortions created in one part of the market to re-emerge somewhere else, the challenge of 2021 and beyond may be to figure out where that might be.

Syl Michelin, CFA®








This piece was part of Walkner Condon’s 2020 Review & 2021 Investment Outlook Guide, a comprehensive interactive PDF covering a wide range of subjects and trends, including the S&P 500, electric cars, and more. To read the full guide, please click the button below.