Tags: Public | Fed | QE | stock

Are Sky High Stocks Headed for a Fall?

Friday, 06 December 2013 07:26 AM Current | Bio | Archive

With the Dow, Nasdaq and the S&P rising to all time highs, are stocks headed for higher highs or a fall?

The answer lies in understanding the three factors sustaining the current bull market.

First, many publicly held companies are generating record profits. But those profits mostly come from aggressive cost cutting and not from increasing revenue. Eventually you run out of costs to cut, so maintaining these record profits depends on generating more revenue from a growing economy.

Also, spending less and cutting wages and jobs may help investors, but does not help economic growth. Most economists believe that the modest and fragile economic growth will be the new normal for the next few years.

Second, many public companies have taken advantage of cheap loans to shore up their balance sheet. Financial engineering like refinancing old loans and stock buyback programs are smart ways to improve profitability, but aside from benefitting investors, they do little to improve economic growth.

Third and most important, the Federal Reserve has flooded the market with an overwhelming amount of cheap and easy money through its quantitative easing (QE) programs. QE was intended to help stimulate economic and job growth through loans, enabling companies to grow, like building plants, hiring workers, increasing inventory and so on. But because of the lackluster economy, financial institutions have invested their huge stockpiles of easy QE money into the stock market because companies have focused on cost cutting and financial engineering and not increasing revenues.

The unintended consequence of the Fed's QE programs has been creating a bull market dependent on QE like an addict is dependent on drugs. The ups and downs of the market are more influenced by the uncertainty of the QE tapering timetable than the usual macro economic factors and stock analysis. And all that money going into a finite number of stocks is generally pushing price-earnings multiples higher than their normal relationships with book values or historical industry trends. These are signs that stocks are getting too expensive and overvalued.

Therefore, be prepared for a possible correction if the Fed announces the start of the tapering of QE and the economy continues its modest recovery. While the tapering will likely start small and slow, as the amount of QE decreases, expect macro economic factors and stock analysis to have more influence on stock prices.

In the process of weaning an addict from addiction, it's often reasonable to expect that for the patient, things will get worse before they will get better.

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With the Dow, Nasdaq and the S&P rising to all time highs, are stocks headed for higher highs or a fall?
Friday, 06 December 2013 07:26 AM
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