The Stock Market’s Recovery Could Be Due to Liquidity Injections

February 16, 2022

Lockdowns in several countries across the world, as well as a dramatic rise in unemployment in the United States, have caused a 30 percent decrease in stock values since March. However, despite statistical estimates of much weaker, possibly negative economic growth and company profits for 2020, stock prices have recently rebounded, surprising many. This stock market rebound makes little sense if the price of a company’s shares reflects the discounted present value of future cash flows to shareholders. However, there is a second key factor that influences stock prices: the quantity of money that central banks make accessible to investors.

Central banks have pumped money into the economy in response to significant stock market falls in previous decades. A measure of this is the size of assets on central bank balance sheets. From US$901,710 million on August 6, 2008, to US$2,212,852 million on November 12, 2008, the FRS assets more than doubled. As the threat of numerous bankruptcies in the banking industry faded, the stock market reacted to the tremendous infusion of cash by regaining a major portion of its losses and climbing well above 2008 levels the following year.

In March 2020, the COVID-19 outbreak caused economic panic. The FRS responded to the panic by increasing its balance sheet assets by 66%, from $4,241,507 million on March 4, 2020, to $7,037,258 million on May 20, 2020: unsurprisingly, the stock market quickly recovered much of its March-April 2020 losses during May-June 2020.

The FRS has pumped large quantities of money into the economy in response to dramatic decreases in stock prices during the last two decades. These price-inducing initiatives have established a not-so-irrational assumption that any future sharp stock price drops will prompt a similar response from the central bank, especially during an election year when political pressure is high. If investors and officials see growing stock prices as usual, and authorities prefer to act to engineer a recovery from extreme drops, it does not seem irrational to expect (as some do) that the stock market will always move up.

The study suggests that in order for prices and underlying values to coincide in securities markets, investors must not only be rational, but also anticipate other present and future investors to behave rationally. The first assumption may be correct, but the second is unlikely to be correct. Even in a world of rational investors, not everyone thinks that all other investors are and will be rational; in other words, belief in the rationality of other investors is unlikely to be general knowledge among investors.

It should come as no surprise that changes in money supply have an impact on stock values in such a society. Perhaps this explains the recent spike in stock prices as a result of significantly higher liquidity pumped by Federal Reserve decisions in the United States.