Insights / Blogs

Insights / Blogs

On The Lookout

James Swanson, Chief Investment Strategist, helps readers make sense of the markets by sharing what he learns along the way.

November 13, 2014

No fooling

Those who say the Fed has inflated an equity bubble are not telling the whole story.
I see five reasons why the stock market’s five-year rise may not be due to easy money alone.
Higher profitability and the US economy’s ability to move forward on its own are also important.

I often hear about the connection between the bond-buying actions of the US Federal Reserve and the rise in stock prices. Indeed, the two do appear to have moved higher in tandem. The S&P 500 Index is up almost 200% since 2009, while the Fed has added trillions to its balance sheet to provide the US economy with extra liquidity to fuel growth and create jobs.

Something else has been happening during the same period, and I would like to draw attention to that. Not only have bond purchases and liquidity measures gone up on the Fed’s actions, but earnings have also risen — in the economy as a whole and by about 190% in particular for the companies traded on the major exchanges.

Over long periods of time, the observed behavior of stock markets has been directly linked to the amount of profits created by companies. That the market is up roughly in line with earnings over five years suggests to me that profitability has been much more of a driving force than Fed liquidity. As I see it, there are five reasons why this is so important for investors to consider.

First, S&P 500 profits have continued to expand throughout this business cycle, well beyond the bounce that could be expected from recession-induced lows. Even in the third quarter, more than five years into the cycle, profits have risen at a rate of about 8.5% year over year as the US economy has regained momentum.

Second, the performance of companies in the major indices has been so robust that profits increased even when the US economy was shrinking. In the first quarter, the US government reported that economic activity contracted by an inflation-adjusted 2.1% — effectively a mini-recession. Earnings rarely, if ever, expand in the face of a shrinking economy, yet we saw that when first-quarter profits rose 4.5% year over year.

Third, the net profit margin — that is, the profit booked per dollar of sales — has continued to rise. To achieve profit margins that now exceed long-term averages by 100%, companies have limited their costs and improved their productivity to a dramatic degree — producing more goods and services per labor hour worked, turning assets more quickly, realizing lower natural gas costs, reaping the advantages of lower interest expense and so on.

Fourth, the gains in profits and profit margins are showing encouraging signs of breadth, occurring simultaneously in nearly all sectors and industries — including the much maligned health care and technology sectors.

Fifth, the US economy is expanding, almost alone among the major economies in the world. In fact, evidence is piling up that the US cycle is moving forward with solid support from consumer income, capital spending, pent-up demand, competitive improvements in global sales, wage gains and falling unemployment rates.

Won’t get fooled again
The investment world is on the lookout for bubbles, wary of asset categories filled with little but air, ready to be punctured by the slightest jab of interest rate increases or the withdrawal of government-injected liquidity. After all, only six years ago the collapse of credit pierced a genuine bubble in the housing market. No one who has sacrificed hard-earned savings to market breakdowns and defaults wants to be fooled again.

But today, there is no major flood of credit sweeping prices upward. Companies and consumers have demonstrated more responsibility with their borrowing. When the private sector borrows, incomes and cash flows are now supporting that debt.

So I agree, let’s not be fooled again. At the same time, let’s not suppose that the Fed is powerful enough to drive up profits in all categories when energy prices, labor costs and asset turnover are helping companies do well. In my view, the market cannot ignore the truly impressive results coming not from a world of liquidity, but from a world of real economy improvements.

No forecasts can be guaranteed.

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.