Earnings used to be the primary driver of stock prices. As
earnings go, stock prices were sure to follow.
That's no longer the case. To be sure, earnings matter. But
today there is a disconnect between earnings and stock
Earnings growth has been "OK," but has slowed each successive
quarter. At the beginning of the year, estimates for
second-quarter earnings growth hovered near 5%. Third-quarter
earnings growth was expected to come in higher - near
Today, Zacks Investment Research expects S&P 500 earnings
growth for the third quarter 2013 to come in at 1.1%. Of the 460
companies that have reported for the second quarter, average
earnings growth was been only 2.1%.
More companies have guided earnings lower in recent months,
prompting analysts to cut estimates for subsequent quarters. At
the same time, the S&P 500 index has moved to record
Year-to-date, the S&P is up 17.5%, and it appears
expensive. The Shiller P/E multiple - an inflation-adjusted
earnings average for the past 10 years - is up to 23.9, a
multi-year high. (The long-term average Shiller P/E multiple is
16.5; the median is 15.9.)
So, we have slowing earnings growth and rising stock
prices. How can this be?
Look to the Federal Reserve. Never in its 100-year history has
the Fed been so influential to asset values and so manipulative
of markets. Then again, never before has the Fed been so
zealous in buying assets and injecting money into the financial
Through quantitative easing - purchasing Treasurys and
mortgage-backed securities - the Fed has injected a massive
amount of new money into the economy. The graph below
reveals how much of that money has found its way into the stock
The blue line is assets on the Fed's balance sheet; the red
line is the price of the S&P 500. The correlation between the
two since 2009 is undeniable.
For much of September, the stock market was aflutter over Fed
tapering - the notion it would reduce its monthly purchases of
notes and bonds. Nearly every Wall Street pundit was expecting
the Fed to taper. When the Fed announced no tapering would occur,
the S&P 500 soared to new highs, even though earnings
estimates were being continually lowered.
Stock-market participants, in short, have become addicted to
the Fed's monetary inflation.
They are also addicted to a corollary of new-money creation -
ultra-low interest rates. The Fed's demand for notes, bonds and
mortgage-backed securities keeps yields on debt low. This further
drives demand for stocks, as more investors turn to equities for
income and yield.
You might ask, why should I care about the Fed's inflationary
monetary policy as long as stock prices keep rising?
For one, manipulation is unsustainable. If the Fed
continues to inject new money at the going rate of $85 billion a
month, we'll end up with Wiemar Republic Germany inflation and an
More basic than that, the risk of a stock-market bust is
imminently raised: The longer a rally is sustained, the more
likely it is to succumb to a punishing sell-off.
Economist Hyman Minsky, in his Financial Instability
Hypothesis, showed that over a protracted period of rising asset
values, economies tend to move from a stable structure to
speculative finance and Ponzi schemes. Given the rise in all the
major stock market barometers that's unsupported by earnings
growth, I see a rise in speculating and scheming.
I'm still invested in stocks, because there are so few
worthwhile alternatives for income investors. But I'm more
vigilant and selective today than I've been in the past four
years. I suggest you be the same.