(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.
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.
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.’