As a former sell-side equity analyst, I just can’t help focusing on the fundamentals that backstop an investment. However, there are times when doing so can mean you don’t pick up on what is really responsible for moving a stock (or even a entire market): good old-fashioned financial engineering. I should know better, having spent the first half of my career working for investment banks.

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If you think this stock market rally is based on fundamentals, think again Back to video

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Back in the early 2000s, during the oil boom, exploration and production companies were turning themselves into income trusts and spinning out explorecos that often began trading at two to three times net asset value, with insiders benefiting tremendously. I remember one exploreco in particular that was being spun out entirely as cash with no land or producing assets and yet was given a two-times target multiple by a fellow analyst.

The problem was whenever I would try and back out the results required from their planned capital programs to fill this huge air pocket of a valuation, the implied return on capital was astronomical, if not outright impossible. And yet, piles of money were made on this trade until it finally ended when the federal government changed the rules around the taxation of income trusts in October 2006, a decision known as the Halloween Massacre.

Fast forward to the past decade, and financial engineering is not just alive and well but this time on steroids. Following the 2008 Financial Crisis, the U.S. Federal Reserve pumped trillions of dollars of liquidity into the market via four rounds of quantitative easing and ultra-low interest rates.

Corporate America did what it does best — especially when given free money — and went on a huge spending spree, from selling products and services at or below cost to establish a client base or by deploying massive share buybacks to help engineer per share growth. The results were astounding: simply pull up a chart of the Fed’s balance sheet and overlay it against the S&P 500, the largest components of which are the megacap technology stocks that benefited the most from this flood of liquidity, to see just how big an impact it had.

For those who don’t like dual Y-axis charts, the R-Squared of the S&P 500 and Fed net liquidity between 2008 and 2022 was 0.841, according to Real Vision and using Refinitiv Data. This means 84 per cent of the observed weekly variation in the S&P 500 can be explained by the Fed net liquidity.

Even the bond market benefited during this time as again, when capital is near free even the tiniest spreads can result in tidy profits when leveraged out over decades. This worked great until the Fed closed the taps to battle inflation and lenders such as Silicon Valley Bank were forced to write down unrealized losses on their unhedged long-duration positions as depositors with a click of a button started withdrawing their money.

This leads us to the real cause of the U.S. equity market’s launch higher in March of this year, and while many of you may think it was AI, there was something more important going on behind the scenes. The Fed once again increased its balance sheet by nearly US$400 billion to support the banks that thought low rates would exist forever. Not surprisingly, the S&P 500 has rocketed 15 per cent since the new liquidity injection, with investors thinking we’re going right back to the good old days again.

But after bestowing the dose of liquidity on the markets, the Fed has since taken it all back and yet the S&P 500 continues to move higher in complete disregard. Long-duration bond markets are having none of it with 20-year plus U.S. Treasuries up only a modest 2.5 per cent since then.

While many are debating whether 30 to 35 times earnings or 7 to 40 times sales for the megacaps is an expensive valuation or not, the answer in our opinion lies in whether the Fed will continue to provide the low-cost funding this financial engineering requires. If it does, then perhaps these multiples are moot and I can put away my analyst hat once again.

That said, I do worry that if the taps don’t start opening again and soon, that the downside risk, especially to the those few stocks that have benefited this year, could potentially lead to another Halloween Massacre type moment in the not-so-distant future.  

Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc, operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning.