Tapering, profit and equity prices

Key points

• As the US Federal Reserve’s tapering announcement is likely imminent, we offer an econometric quantification of the effect of the Fed’s quantitative easing (QE) programme on US equity prices, also taking into account interest rates, earnings and market stress
• Over the last two years, QE appears to explain nearly all the gains in equity prices in the S&P 500 index. However, we find that the information technology (IT) sector has been much more sensitive to QE than the rest of the index
• This does not necessarily mean that a correction is unavoidable when tapering starts. In our model, it is only when the Fed actively reduces its balance sheet by selling the securities it has acquired during QE that equity prices would be squeezed. We use our model to simulate what pace of Fed asset offloading would be consistent with stable equity prices
• Our model suggests that actual corporate earnings have no bearing on the equity valuation of IT stocks – contrary to what we find for the rest of the index. Only expected earnings seem to matter, and they have little connection with actual ones.