Global stock markets pulled back in early September, after a remarkable run that seemed to defy the reality of recessions around the world. Despite recent volatility, we think market gains for the year are more rational than perceived, given the powerful impact of stimulus and low rates on stock valuations.

Nearly 24 years ago, US Federal Reserve Chairman Alan Greenspan coined the phrase “irrational exuberance” to refer to inflated equity markets that might have lost touch with reality. In 2020, the COVID-19 pandemic prompted a collapse of economic growth. However, world equity markets are up year to date—and the technology-heavy NASDAQ has surged nearly 25% this year through September 15. So, how are investors reconciling this year’s terrible economic data with the market’s exuberance through early September? Is it rational, or irrational?

Stock Investors “Don’t Fight the Fed”

In some ways, market gains from late March through September are surprisingly rational. There’s an old adage in investing: “Don’t fight the Fed.” This means that when interest rates are falling and central banks are loosening monetary conditions, some of that money will make its way into the stock market and push up prices. That’s a rational response, because looser monetary conditions should stimulate economic activity, which in turn should boost corporate profitability, justifying higher share prices.

Central banks have taken unprecedented action to provide liquidity for the financial system over the last six months. Since developed markets began to lock down economies in an effort to control the novel coronavirus pandemic, central banks have cut interest rates to historic lows and launched quantitative easing measures, such as using their balance sheets to buy corporate debt and government debt. We’ve never seen anything like this, even at the height of the global financial crisis. Aggressive central bank purchases of government bonds in the US, Europe, Japan and the UK (Display) allow governments to issue more debt and suppress the cost of that debt, which has a very powerful effect.

But where has all this enormous stimulus gone? Not into capital investment, with the exception of some work-from-home beneficiaries—such as Amazon.com—and government healthcare expenditure. Instead, much has gone into increased saving, some of which has made it into the stock market.

In addition to monetary stimulus by central banks, governments have also been providing unprecedented fiscal stimulus (Display). So, perhaps the new adage should be, “Don’t fight the Fed and the Treasury.”