Does the stock market care about the after-tax profits generated by corporations? Not in the era of Federal Reserve QE (a.k.a. “quantitative easing,” “balance sheet expansion” or “electronic money printing.”)
Over the last five years, stock prices for the S&P 500 have gained more than 50%. Meanwhile, after-tax profits at non-financial companies have actually declined in the period. Is that sustainable?
Credit the Fed for its QE-inspired wealth effect.
Some believe that the Fed stopped QE when they halted purchases with the creation of new electronic credits at the end of October 2014. However, a more nuanced explanation is that the Fed maintained QE levels above $4 trillion straight through the start of 2018. Maintaining an elevated balance sheet with the aid of trillions of reinvested dollar credits is still QE.
There was a small amount of tapering in 2017. Yet that was offset by corporate tax reform stimulus. In 2018, the Fed attempted to reduce its balance sheet in earnest. Then the S&P 500 fell 19.9% in Q4.
What did the central bank of the U.S. do to resurrect the wealth effect? It completely flip-flopped on everything from interest rates to what it should do with its balance sheet.
Instead of raising rates four times in 2019, they slashed rates three times. And, not surprisingly, the Fed’s “funny money” balance sheet has puffed back up to $4.1 trillion.
Without a doubt, the Fed’s easy money liquidity has been the driver for 2019’s stock market recovery and subsequent record highs. Profits? Earnings per share (EPS) actually decreased in 2019.
Granted, there have been stretches in history when financial markets disregard profit trends. When it has happened, though, stock valuations became bubbly.
Objective measures for asset price valuations — price-to earnings (P/E), P/E 10, market-cap-to-GDP, price-to-sales, Q Ratio, regression-to-trend — have been pointing to extremely overvalued conditions for years. Circumstances may not be as fizzy as they were in the year 2000, though they are frothier than they were in 1929 and 2008.
The uninformed response to the data is that traditional valuations do not account for “ultra-low” interest rates. On the other hand, one can easily debunk the myth that low interest rates alone justify extreme valuations.
Consider the fact that the U.S. experienced a similar low interest rate regime for 20 years from 1935-1954. Traditional valuation metrics did not reach the extraordinary heights of 1929, 2000, 2008 or 2019 during the 20-year period from 1935-1954. (See the chart above.)
Economic growth was far greater during the 1935-1954 period than it has been in this decade. Nevertheless, the ultra-low rates in those years still did not derail bear markets from occurring in 1937-1938 (-49.1%), 1938-1939 (-23.3%), 1939-1942 (-40.4%), or 1946-1947 (-23.2%).
Investors need to see the current environment for what it is — a QE-fueled wealth effect.
Think about it. How does the Fed hope to stimulate job growth and achieve stable inflationary targets? The members of its voting committee look to push up asset prices to make consumers and businesses feel wealthier and, subsequently, spend money.
Businesses did some spending, of course. Yet less had been allocated to human resources and capital expenditures than to stock buybacks. Now those corporations have some of the worst debt ratios in their history.
Consumers have been the true saviors. They still have jobs, so they keep on spending.
Still, the signs that consumers may spend less are evident. Job growth is waning, year-over-year retail sales are slowing and expectations about the economic future are falling. In fact, the gap between present circumstances and future expectations is worse than it was in 2008 and nearly as bad as it was in 2000.
If the economy stagnates, or if the bond market sniffs out ongoing weakness, the Fed will continue to increase its balance sheet and cut overnight lending rates even more. Voting members have no other plan.
Many wonder what the catalyst for a wealth effect reversal might be. Yet a catalyst may not be easily identifiable and it may not be singular.
Keep in mind, there is no agreed-upon catalyst for the bursting of 2000’s tech bubble. The Fed was too loose with policy in the late 1990s? Then hiked rates too far? Then cut too slowly? That’s part of the story.
It follows that a combination of factors can come together to produce a rapid unwinding. Here are a handful of potential contributors (in no particular order):
1. Fed Policy Error. Asset prices may fall because the markets become dissatisfied with the pace of QE or the amount of QE or any other aspect of policy (e.g., rates, forward guidance, inadequacy of a new tool, etc.).
2. Market Uneasiness Over Unsustainable Borrowing Cost Path. Clear across the world, inflation-adjusted interest rates are negative. That which led to over-borrowing could serve as a direct or indirect catalyst, particularly as it relates to the possibility of a fallout from a downgrading of BBB-rated corporates and/or a crisis in the leveraged loan arena.
3. Fewer and Fewer Share Buybacks. Corporations borrowed by the boat load to shovel the money back into their stock shares. That support is already slowing, with share buybacks 30% lower in 2019 than in 2018.
4. Complete Loss of Faith in Global Trade. The global manufacturing recession may become contagious. Tariff removal and trade deals may come along too late, or never amount to anything meaningful. Four consecutive ISM readings below 50 raises the risk of a pile-up in layoffs.
5. A 4.1% U-2 Unemployment Rate. “Are you nuts, Gary? 4.1% is remarkably low in the history of this country.” That may be true, yet it also represents a 0.5% rise above the cyclical low of 3.6%. Every recession since 1970 occurred when the three-month average unemployment rate rose at least 0.5% from its 12-month low.
None of the aforementioned contributors have occurred… yet. Any or all of them could occur in 2020.
One of the ways that an investor can still participate in market upside with less fear about a bearish wipe-out is with a “Defined Outcome ETF.” For example, December’s incarnation of the Innovator S&P 500 Power Buffer ETF (PDEC) seeks to track the return of the S&P 500 Price Return Index up to 8.92% (12/04/19) at a price of 26.33, while buffering investors against 14.56% of losses through 11/30/2020.
Income-oriented investors may be more inclined to stick with dividend aristocrats that have raised their dividends for 40-plus years. Talk about reliability through thin and thick!
Johnson & Johnson (JNJ), PepsiCo (PEP) and Clorox (CLX) “screen” more favorably than others. That said, none of them are inherently cheap.
Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.