At last month’s Portfolio Construction Forum summit in Sydney, almost every presenter – from economists to fund managers – was critical of central banks for “artificially inflating asset prices” with “excessive liquidity”, leaving financial markets “addicted to easy monetary policy”.

Indeed, US journalist Christopher Leonard recently published a book called The Lords of Easy Money: How the Federal Reserve Broke the US Economy, which “tells the shocking, riveting tale of how quantitative easing is imperilling the American economy”.

On the face of it, the numbers are confronting. Before the start of the COVID-19 crisis in February 2020, the US Federal Reserve’s balance sheet stood at $US4.4 trillion. Two years later, after a program of buying government bonds and mortgage-backed securities known as quantitative easing (popularly referred to as QE), it has more than doubled to $US8.9 trillion ($12.3 trillion).

Similarly, the Reserve Bank of Australia has also conducted its own QE program, expanding its balance sheet from $180 billion before the pandemic to about $650 billion.

It sounds intuitive and seductively simple: central banks print money; they’ve expanded their balance sheets by trillions of dollars; all that newly printed money has inflated asset prices. Unfortunately, it is dead wrong but, as is often the case in financial markets, it’s the prevailing narrative that’s been repeated so often that people believe it.

In his book, Leonard describes how, under the QE program, the Fed will buy bonds off a bank by crediting that bank’s “reserve account”, which, in simple terms, is a special account that only banks who transact directly with the central bank can have. He then claims those banks are free to use those reserves “to buy assets in the wider marketplace”.

That just isn’t how it works.

What really happens is far more complicated, and far less exciting. Those reserves, which in Australia are called exchange settlement reserves, are a special kind of currency that is only transacted between the central bank and other commercial banks to make sure the billions of transactions the banks undertake daily settle every day. Those reserves are not the same as the cash used in the real world.

Central banks will also buy bonds from other institutions that don’t have a special reserve account with them, in which case they do settle with normal cash. However, according to the Reserve Bank’s website, those institutions are all credit unions, smaller banks or insurance companies. If an institution like that is holding bonds in the first place, which are classified as a defensive, fixed income asset, it is pretty much guaranteed they are not going to take the money and punt it on cryptocurrencies.

So what caused financial markets to rebound so aggressively if it wasn’t central banks printing money? It was governments, by injecting trillions of dollars, pounds, euros, yen and other currencies into economies to support them during the COVID-19 crisis.

That money was created out of thin air and is still circulating around their respective economies. In fact, governments create money in a keystroke via fiscal policy every day, with things like social security payments or any other spending program.

Many will argue it was central bank QE programs that allowed governments to run deficits – but this is not true either. Just like before QE, it’s the government spending money into existence that provides the cash for banks and others to buy the bonds. Central banks are not required to do anything other than conduct their normal daily monetary operations of targeting interest rates.

That the central bank QE programs did not drive the share market means the tapering of QE, or allowing their balance sheets to shrink, does not necessarily have a negative impact on the share market.

Chris Bedingfield, a portfolio manager at Quay Global Investors, points out that in the first three QE programs, the S&P 500 went up by an average of 2.2 per cent in the month after a QE “event”, be that the commencement, announcement of tapering, or conclusion of QE. On average, regardless of whether the announcement indicated an easing or tightening of central bank policy, a month later US equities were higher.

That does not mean share markets cannot fall – but if they do, it will have more to do with other factors, like valuations, fear, geopolitics or even inflation rather than central bank actions.

The most commonly used valuation measure for share investors is the price to earnings ratio, which is typically referred to as the PE. It’s the price of a company’s share divided by the earnings per share the company either has, or is expected to generate, and it tells you how many years of earnings it would take to repay your investment.

The higher the PE, the more faith investors are placing in a company that it will perform well into the future. Another way of saying that is the higher the PE, the more expensive are the shares.

The PE, and variations on it such as the CAPE ratio (which uses rolling 10 years of real earnings) are constantly referred to by analysts and strategists as the benchmark of determining whether a particular share, or the market overall, is fairly valued or not.

However, the PE ratio suffers some shortcomings as a valuation tool. First, it is heavily influenced by sentiment, both positive and negative, plus it can be affected by inflation. Another problem is that while the P part is indisputable, the E part can be subject to the peculiarities and interpretation of accounting rules, which can make an enormous difference and render the PE all but meaningless.

Legendary analyst, Michael Mauboussin, Head of Consilient Research on Counterpoint Global at Morgan Stanley Investment Management, argues in his new book Expectations Investing, that the PE ratio is pretty much useless.

One of the critical reasons behind that surprisingly robust assertion is the rise and rise of ‘intangible assets’ on company balance sheets, especially in the US.

Tangible assets are things you can touch, like buildings and machinery. They are entered onto a company’s balance sheet as a capital item and treated as an asset.

Intangible assets are things that you can’t touch but are nevertheless an asset to the company, such as patents, trademarks or goodwill. Notwithstanding these can be the most valuable assets a company holds, the spending that goes into building them, like R&D, or marketing, or paying up for talented staff, is treated as an expense to the company and therefore reduces reported profits, which in turn reduces the reported earnings per share.

In 1975, the US share market was dominated by companies like General Electric, Ford, GM and oil companies, and intangible assets accounted for only 17 per cent of total S&P 500 assets. By 2020 the biggest companies were Apple, Microsoft, Amazon, Facebook and Google and intangibles had grown to be 90 per cent of assets.

In their book The End of Accounting, the authors, Lev and Gu, argue centuries old accounting principles are inappropriate for intangible-rich companies and concluded the ability of reported earnings and book value (the anchor for two of the most widely used ratios, the PE and price to book value) to explain share market values declined by an incredible 6 per cent per year between 1950 and 2014.

As Mauboussin points out, at the end of the day, what matters most is how much cash a company produces, not earnings. What this means is that when you see a tech company trading on what looks like an outlandish PE, it could simply mean the market is looking way beyond the reported earnings and instead is factoring in how much cash it thinks that company’s intangible assets are going to generate.

Kai Wu, principal of Sparkline Capital in the US, argues that if investors want to understand the value of intangible assets, they need to move beyond the limited information available in financial statements. On their analysis tangible assets make up less than 45 per cent of total value in six of the eleven sectors that make up the S&P 500, with things like network effects, brand equity, human capital and intellectual property making up the balance but not even rating a mention in financial statements.

Sparkline uses AI to analyse the mountains of data companies produce that reflect their intangible assets and incorporate the results into their valuations. The results are impressive, with backtests producing annualised returns more than 30 per cent higher than the S&P 500 over the past 25 years.

When you hear or read market commentators saying the PE ratio is way out of whack compared to its long-term average, the smart investor should first ask why that might be, not necessarily to rationalise it, but to understand it.

So far, 2021 has been another year of stellar stock market returns across the developed world. To the end of November, the Australian share market has delivered 14 per cent, the US 25 per cent, and even dusty old Europe has managed to rise 14 per cent, with the only real laggard being the emerging markets, which have struggled under the deadweight of a Chinese market coming to terms with new regulatory concerns, returning 8 per cent.

As we approach the end of the year, it’s an opportune time to take stock of what the drivers of those strong returns have been and the likelihood of them being sustained.

At the heart of the global economic bounce back over the past 12 months, and helping to underwrite the strong financial markets, was the massive government stimulus payments to compensate for the expected drag from COVID. The OECD estimates governments around the world spent more than $19 trillion combined on COVID-related support programs. You have to go back to global wartime to find a comparable period of fiscal spending.

All that money has to go somewhere, and whilst some of it has been saved, much entered the economy and inevitably found its way into company revenues. Australian companies reported close to record earnings growth of more than 26 per cent for F2021 and paid out a record total of $67 billion in dividends. In the US, analysts are forecasting companies to report 40 per cent earnings growth over this calendar year and globally it’s an amazing 48 per cent.

Over the long run, earnings growth is the principal driver of share prices, and Citigroup’s forecast for global earnings growth drops to a far more typical 8 per cent for 2022.

There are also short-term drivers of share prices. In what’s come to be known as the ‘TINA’ effect (There Is No Alternative), money has flooded into equities chasing higher potential returns than what’s on offer through anaemic bond yields.

According to Bank of America Merrill Lynch, rolling 12 month flows of money into equity funds topped more than $1.5 trillion earlier this year, almost four times its previous highest peak. Incredibly, the $1.25 trillion invested into equities funds between January and November this year is more than the total amount over the same period for the previous 19 years combined!

That remarkable amount of liquidity has also underwritten a record year for global initial public offerings (IPOs), or company floats, worth more than $830 billion.

Another short-term driver is referred to as ‘seasonality’, which is the average performance of stock markets over a year. If you look over a long enough period it becomes apparent that money flows follow a pattern. The chart shows the Australian share market tends to experience a rally around April and October each year, which is after dividends have been paid, and for both the Australian and US markets, the December quarter is normally the strongest.

Seasonality of the Australian and US share markets, 1991-2020

Another influence on share markets has been the reluctance of central banks to temper their super accommodative monetary policy, despite coming under concerted pressure from the bond market in the face of sharply higher inflation data.

Although the Reserve Bank of Australia abandoned its quantitative easing policy, it has retained a record low cash rate of 0.1 per cent and insists it’s not even close to raising it. Meanwhile, the US Federal Reserve has kept both its low rates and its QE program in place, and likewise assures markets it’s in no hurry to tighten.

As always, like placard waving protesters, there are bears who are keen to spoil the party. Valuations have undoubtedly become a lot more stretched over the year, and amazingly the total market capitalization of US companies with a price to sales ratio of more than 20 times has rocketed from about US$300bn to more than US$4.5 trillion in just the last 18 months, a level 25 per cent above the notoriously bubbly dotcom boom of 2000.

So, between the biggest peacetime government spending program in history and the lowest cash rates in history, perhaps it’s not surprising share markets have done very well this year, until you throw in that it’s happened during the worst global pandemic in a century. It makes you wonder what 2022 holds in store.