How the Fed Distorts the Stock Market, and Why You Should Beware

The Fed’s easy money and low interest rate policies might have saved the economy from severe depression since 2008. But it definitely has had other effects. One effect is to distort investment markets, especially the stock market. If you’ve been following headlines, you’ve seen that few active mutual fund managers have beaten the stock indexes in recent years. Does that mean there aren’t any good stock pickers left?

Perhaps not. In this article, mutual fund managers with excellent long-term records but poorer records in recent years argue that the Fed distorted the stock market, boosting the returns in poor quality companies. Study it closely before deciding how to change your portfolio.

“We have been using the same process to pick stocks for 40 years and we have confidence in it,” Frank Gannon, co-chief investment officer for Royce, said in a telephone interview.

In his view, the Fed keeping interest rates near zero for the past six years has had the “unintended consequence” of boosting the stocks of companies with heavy debt and little or no earnings.

Typically after a recession, such companies lose out to firms that generate more cash and have better balance sheets. This time, no “Darwinian” shakeout happened and low-quality stocks ruled, Gannon said.

“There has certainly been little reward for owning high-return, superior business models that are conservatively financed,” Neuberger Berman’s small-cap stock team wrote in an October 2013 paper titled “Is There Hope for Active Managers?”