Last week witnessed perhaps the clearest indication yet of the US Federal Reserve’s plan to let both short-and long-term interest rates rise in the near future. Coincidentally, earlier this month, the Standard & Poor’s 500 (S&P500) marked the fifth anniversary of a bull run that began after the crash. The Dow Jones Industrial Average (DJIA) too, while lagging behind its peer, has notched up an impressive performance, flirting with new highs.
Bullish investors have justified the rally in the US equity market citing improvement in companies’ earnings in the light of a recovering economy. With S&P500 earnings per share (EPS) rebounding by almost 70% from market bottom, the current rally looks justified at first sight. However, there is good reason to be wary of the current exuberance in stocks.
While earnings of S&P500 companies have clearly improved, much of this has come about through some unimaginative financial engineering. According to JPMorgan Chase and Co., almost 60% of improvement in S&P500 earnings from Q3 of 2011 to Q1 of 2013 came about through share buybacks—and not organic growth. The practice has been supported by the low interest environment which has made it congenial for corporations to fund such operations at low cost. The real reason behind the equities rally lies elsewhere.
While the Fed has never admitted to targeting stock prices as a matter of policy, raising equity prices—by forcing investors to reach for yield—has clearly been part of the central bank’s game plan to stimulate spending. As is widely known now, the Fed has been on a printing spree, expanding its balance sheet to over $4 trillion from less than a trillion dollars in 2008, and driving down yields on short-and long-term securities.
This has successfully pushed investors into equities: the current proportion of US household allocation of funds towards equities, standing at 24% of total assets, is bettered only by the record set during the Internet bubble era. Also, interestingly, there is a near-perfect correlation between the performance of the S&P500 and the Fed’s balance sheet.
There are several other signs of froth which could warn of an impending collapse. Data from the New York Stock Exchange (NYSE) shows margin debt (adjusted for inflation) to be at an all-time high—matching the S&P500’s trend of breaking multiple previous highs. Initial public offerings (IPOs) have been the greatest beneficiaries of this flush of liquidity, particularly companies with negative earnings which make up 74% of all IPOs. All the while corporate insiders have been net sellers of equities—being the most bearish in the last quarter of a century.
With much of the exuberance in stocks driven by liquidity poured into the market by the Fed, the current decision to tighten liquidity will pummel stocks on two fronts. One, much of the illusory profits driven by the Fed’s expansionary policy is likely to slow down. With median household income and real disposable income continuing to slide, it looks unlikely that earnings will pick up to justify current valuations—which look overstretched even by S&P500’s trailing earnings figures given their poor quality. Secondly, higher yield on bonds—in a more market-driven fixed income market—is not good news for equities. Historically, higher rates have led to gloomy performance of stocks as higher yield on risk-free securities translates to higher discounting of future cash flows from stocks, which basically means lower stock prices.
Investors should brace themselves for the bursting of yet another equity bubble, courtesy the Federal Reserve.