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 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 —