BAD NEWS = GOOD NEWS, YET AGAIN

(This is an excerpt from a recent Value Alert Newsletter, 11/8/2015)

When it comes to stock prices, how much do the anticipated movements of central banks matter when compared to the fundamentals of publicly traded corporations?

Did it matter that in Caterpillar’s (CAT) recent conference call with investors, it disclosed that 2016 revenue would collapse by 5% across all of its market segments? Did investors worry about 3M’s (MMM) intention to reduce its global workforce by 1500 positions because of lousy earnings? No way. Investors now expect substantial financial rewards for taking a risk when central planners engage in what is clearly blatant price manipulation.

Ironically, declines in revenue and earnings from companies like Caterpillar and 3M only confirms the weakness in the global economy, which investors now take as good news. Weaker results increase the likelihood that central banks will step up their stimulus measures.

So does central bank stimulus and low rates make that big of a difference? Just how powerful is the combination of quantitative easing (QE), zero-percent rate policy and even negative-percent rate policy? Omnipotent.

As an example, let’s use the performance of Vanguard Total Stock Market Index (VTI) as it relates to the activities of central banks engaging in QE. As a specific example, in mid-December of 2012, the U.S. Federal Reserve increased its QE3 program to $85 billion per month to buy U.S. Treasuries and mortgage-backed securities. The effect on the stock market, as measured by VTI, was impressive.

All-market index (VTI) 2013-2014

VTI made an average annual return of 24% per year during 2013/2014 with QE3 underway.

VTI opened 2013 at $70.78 and closed 2014 at $104.52. That’s a 48% gain for those two years or an average of 24% return per year. Those are impressive numbers when the long-term annual market average return is closer to 7%. But what happens when the Federal Reserve removes the punch bowl of stimulus?

The US Fed stopped its QE-related asset purchases in mid-December of 2014. The 2015 performance for VTI without QE should give us a clear measure of the effect of the stimulus. VTI opened 2015 at $105.01 and closed on Friday at $107.84 following a wild ride of volatility during Aug, Sept, and Oct. That’s a gain of only 3.2% year-to-date when QE isn’t a factor affecting prices, compared to 24% per year with QE. Imagine what could happen if the Fed soon increases interest rates.

All-stock index (VTI) 2015

However, during 2015, with no QE working, VTI logged a gain of just 3.2%.

These extraordinary financial shenanigans that have carried the market to within a few percent of its all-time high continue to override what have been deteriorating economic fundamentals. Tightening financial market conditions in the form of an interest rate increase will reduce speculation, and market prices will plummet. Because of this, merely the discussion of a rise in interest rates causes the market to dive, as it did in August.

The stock market has been robust with QE in place and sideways and extremely volatile without QE. The single most important factors (sales and profits) used to determine stock valuations and forecast future prices have been in decline on a year-over-year basis since the beginning of 2014 and negative in 2015. Still, stock prices continue to remain near all-time highs based on the ‘Fed Put’ that has been in place since the Alan Greenspan era in the Federal Reserve began.

Most market historians hold former Fed Chairman Greenspan responsible for the low-interest-rate-sparked market bubble associated with the internet enthusiasm in the late 1990′s, as well as the housing-related bubble created in the mid-2000′s by super-low rates that ultimately resulted in the Financial Crisis when the Fed steadily increased rates to a level that was too high. The Federal Reserve has an undeniable history in the last 20 years of creating bubbles, and then in attempting to cool off the overvalued assets, crashing the economy and causing the financial displacement of millions of families. What is their solution to this history? Apparently, more of the same, and this time it could be a real doozy since now we have the entire world on the ‘bubble-creation program.’

AN INCONVENIENT TRUTH: EXPENSIVE PRICES + POOR FUNDAMENTALS = DISASTER

When we made the decision to use ETF’s instead of value stocks in our October 25 Value Alert newsletter, it was a decision based on practicalities. Value stocks have simply stopped working as the bull market has matured. However, we now feel that the entire market is reaching valuations that may be closing in on obscene. Here’s why…

When the October 25, 2015 newsletter (in which we lamented the overvalued conditions) was published, we commented that the S&P 500 P/E ratio was at 18.23 and the Russell 2000 P/E ratio was at 71.7. The average P/E ratio for the S&P 500 since the 1870′s has been about 15.5, so the S&P 500 was slightly elevated two weeks ago. Data for the Russell 2000 is not as readily available, but according to Russell Investments, which introduced the indices in 1984: “The average P/E of the Russell 2000 since 1998 has been approximately 17.0, vs. 13.5 during the period (from 1984 to) 1998.” Therefore, the Russell was extremely overvalued two weeks ago. But now, it has a valuation that is jaw-dropping.

In writing today’s article, I just checked in with the Wall Street Journal Market Data Center to get an update. The S&P 500 P/E ratio is now significantly higher at 23.41, and the Russell 2000 P/E ratio is at a mind-boggling 188.46. Check for yourself.

EARNINGS AND REVENUE RECESSION CONTINUES

Those incredibly high prices are accompanying declining revenues and profits, a trend that we have discussed several times in previous newsletters.

In the current earnings reporting period, nearly one-third of S&P 500 corporations have reported earnings and revenue from the third quarter. With 147 companies reporting so far, profits are down -0.6% and sales are down -2.7% from a year earlier.

151108_declining_revenues_and_earnings_smIt seems logical that several quarters of contraction in earnings and revenue would have weakened stocks. After all, if robust sales and healthy profits are the primary drivers behind price appreciation for publicly traded companies, shouldn’t diminishing sales and dwindling profits lead to price drops for publicly traded corporations?

Welcome to the bizarre world of central-bank planning, worldwide stimulus, and currency wars in a race to the bottom. Despite the plummetting fundamentals, the S&P 500 is within 2% of its all-time high and the Nasdaq 100 set a new all-time high last week. And, of course, the Russell 2000 has the highest PE ratio ever recorded!