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Is the Fed Getting Too Much Credit for This Rally?

May 3, 2013 in Economics

By Alan Reynolds

Alan Reynolds

If the U.S. economy is so bad, why has the stock market been so good? A commonplace answer is that the Fed pushed stocks too high by pushing bond yields too low. In fact, that is why many worry that …

There are only two ways the Fed’s bond-buying spree could have pushed stock prices up, and neither is consistent with reality. One way the Fed might have raised stocks would be through improving fundamentals — namely, earnings. Unsurprisingly, stocks hit a new high after earnings hit a new high. Earnings per share for the S&P 500 last peaked near $22 in mid-2007, and then fell below zero at the end of 2008 before rebounding to about $25 by the end of March. But it would be problematic to give the Fed much credit for the cyclical rebound in earnings, considering the weakness of the recovery.

Earnings per share can rise because of stock buybacks or cost-cutting, after all, which have nothing to do with monetary or fiscal “stimulus.” Cheap credit encourages cost-cutting by investing in labor-saving machinery, but that aggravates unemployment. Lower interest rates surely boosted profits of leveraged corporations. But the flatter yield curve (e.g., “operation twist”) squeezed bank margins, while near-zero returns reduced the interest income of cash-rich tech firms. Lower interest rates likewise helped indebted consumers, but had the opposite effect on the incomes of seniors and other prudent savers.

There are only two ways the Fed’s bond-buying spree could have pushed stock prices up, and neither is consistent with reality.”

In short, the net effects of quantitative easing on corporate earnings appear ambiguous at best. Yet the only other way Fed policies could have lifted stock prices would be by raising the ratio of stock prices to earnings — the price-earnings multiple. Before 2009, it would have been perfectly reasonable to expect any Fed-induced drop in bond yields to be reflected in a higher p-e multiple. Stock prices mirror the discounted present value of future earnings, which usually leads investors to bid up stock prices whenever longer-term interest rates fall. This is why it makes no sense to worry that the recent p-e ratio of about 18 on the S&P 500 is slightly higher than the long-term average of 15 without taking into account that yields of 1.8% on 10-year Treasury bonds are immensely lower than the average of 5.5%.

Let’s consider how …read more

Source: OP-EDS

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