The Wall Street Casino Is Open Courtesy of the Fed

Casino slot machine winnings like stock market returns?          Photo Credit: Wikimedia Commons/Raul654

By now it is common knowledge: Currently the results of the U.S. stock markets have next to nothing to do with growth in the economy, nor with growing revenues of corporations. As just one example of the general recognition of this fact, consider the post This is the Worst U.S. Earnings Season Since 2009 by Blaise Robinson on Bloomberg.com. In it Robinson reports that with about three-quarters of the S&P 500 companies having reported, the average earnings per share (EPS) are down 3.1% in a share-weighted average. Not only that, but eyeballing their bar chart of how average EPS has changed over the quarters, the same average was down about 1% in the second quarter and was up less than +1% for the first quarter. Not only that but their bar chart shows average stock EPS falling every quarter since the end of the second quarter of 2014. Yet as the candle chart below demonstrates, until recently at the end of August, the S&P 500 index has just kept growing.

All through the first part of 2015, stocks were gently rising with a few minor corrections from time-to-time, until around the beginning of April when the S & P 500 began to form a top. Then around August 20, there was a large fall in the S & P 500. What was the worry that caused the fall? Was it about a deteriorating economy? In fact most of the internet discussion was on whether the Federal Reserve was going to start increasing interest rates in October. When October came, the news that the Fed would not increase rates until at least December, caused a market rise that almost obliterated its fall at the end of August. What role did the accelerating decline of average EPS play? Apparently that little consideration played no role at all. Most recently it looks like the S & P 500 is trying to put in another top with resistance around 2110.

U.S. Economic Health and GDP Growth

The next question to ask is: How healthy is the U.S. economy? Could an improving economy be at least part of the reason stock values want to stay so high? The collective judgement from the posts What is the Economy’s Condition?, What Does Falling Money Velocity Tell Us?, What Do Others Think About the Economy?, and Cognitive Dissonance is that the economy is in pretty sad shape, albeit not yet in recession. On the Leading Economic Indicators page under the Statistics  main menu item above, you will find a number of leading indicators graphed to show their recent behavior through recent years. Currently, one indicator is bullish, six are neutral, and five are bearish. Although the net signal of all the indicators is bearish, the large number of neutral indicators suggest caution in any investment decisions. From what these leading indicators tell us, although the economy is strongly leaning toward decline and recession, it is still conceivable the economy may turn around and begin expanding at a faster rate.

Nevertheless, we have other reasons for thinking the United States is heading for recession. First, there is all the economic damage perpetrated by the Federal Reserve on the economy, as I discussed in Economic Damage Created by the Fed. Second, there are the immensely destructive economic regulations promulgated under the Obama administration, described in The Burden of Economic Regulations, The Debilitating Effects of Obamacare, Economic Effects of the Dodd-Frank Act, and The EPA, CO2, Mercury Emissions, and “Green” Energy. Finally, there are all the myriad ways in which current tax policy discourage economic growth, as related in the post Economic Effects of Current Tax Policy. How many times can government policy kick the economy in the gut before it goes down for the count?

Corporate Strategies to Keep Stocks Attractive

Then, if the economy has not had impressive growth, why has the stock market grown so much from 2008 up until this year? To demonstrate this low GDP growth, I will plot the GDP below over a longer time period, from the beginnings of the Great Recession in 2007 to the present. The actual GDP is the blue curve, while the percent change of the GDP from a year earlier is the maroon curve.

From the GDP’s percent change from a year earlier, it appears GDP growth has entered a damped oscillation about an equilibrium at two percent growth, a very subpar performance as recoveries go. If this continues, it is very hard to see stocks returning anything more than this low value per year. After all both the costs and the profits of all companies each year come out of GDP, and on average can grow no faster than GDP. Yet in 2013 the S&P 500 gained 31%, and in 2014 it was up a still respectable 14%. How could this happen with GDP growth in the doldrums? The answer to this question comes in several parts.

1. First, the Federal Reserve has been injecting a huge amount of money into the economy for about six and one-half years through their ZIRP and QE programs. In the process they have kept both short-term and long-term interest rates very close to zero. The QE program did end in October 2014, but its effects linger because the Fed has made no move to sell off any of the long-term assets it bought under QE. ZIRP continues. I will grant you only about 20% of the QE injections made it into the economy with 80% recaptured by bank excess reserves with the Federal Reserve. I suspect the Fed viewed this 80% as a fund they could slowly release into the economy if growth increased. They never got the chance. Even so, the 20% that did make it into the system was still a large chunk of change.
2. At the same time economic regulation of banks under the Dodd-Frank Act has made it very difficult for banks to lend to individuals and to small businesses. As a result banks have been lending primarily to their most credit-worthy customers: large corporations.
3. Simultaneously, these same large corporations have found the U.S.environment to be a hostile place in which to make investments, for all the regulatory and tax reasons I cited above for believing a recession approaches. As a result large corporate investments have languished.
4. What did corporations do with their money? Not only did they spend it, but under the influence of zero real interest rates, they also borrowed and spent. And what did they spend it on? Why, to buy back their own stocks to make their PE ratios lower and therefore more attractive in the stock market! By decreasing the total number of their stocks outstanding, they increased the earnings per share, even if earnings had increased only slightly or not at all.

There in a nutshell you have an explanation for what happened to a large part of the QE cash that made it into the economy, as well as for what has caused the stock market boom in the face of declining earnings and a probable contracting of the economy. None of this bodes well for our future economy; nor does it bode well for the economic welfare of stock market investors. A very large fraction of the economic crises over the last half-century or so would not have occurred if the central bank had not enabled it by blowing up an asset bubble.

What Will the Fed Do Next?

The Federal Reserve Open Market Committee (FOMC) has been saying that it is data driven in trying to decide when to increase interest rates. By now it should be obvious what they really mean by this is that they are dependent on the volatility and growth of the stock markets. This is also becoming a widely recognized fact as you can see in the post Market To Fed: Plata O Plomo? by Charlie Bilello. The picture he paints is of a Fed depending on a “wealth effect” to get investors and companies enthused enough to invest scads of money into new productive capacity, thereby stimulating and lifting up the economy. Then when the stock market gets the idea the Fed just might raise interest rates, removing “free” money at zero real interest rates to fuel a further inflation of the stock market bubble, they have a tantrum and threaten to start a stock market sell-off. This behavior then alarms the FOMC into keeping money loose so that they do not lose their precious wealth effect. Round and round the markets and the FOMC have gone, each pushing the other and resulting in the maintenance of zero real interest rates.

Since it is now perfectly obvious to everyone that the Federal Reserve plan has utterly failed (see Quantitative Easing and Its Effects and Why have ZIRP and QE Failed?); and that in pursuing this plan, the Fed has actually wreaked considerable harm on the economy (See Economic Damage Created by the Fed); one might have expected the Fed to reverse coarse and to gradually increase interest rates. Unfortunately, as I discussed in Is It Even Possible for the Fed to Raise Rates?, the Fed might be caught in a particularly vicious catch-22. If the federal government can not depend on zero real interest rates in financing the national debt, particularly in a time when sovereign wealth funds all over the world are dumping U.S. Treasury bonds on the international market, how much will the Fed strain the servicing of the national debt if it raises real interest rates? Would it be the straw that broke the camel’s back? Many believe the FOMC will inevitably raise interest rates in its December meeting. I am holding my breath. As for the stock market, if you want to invest in it, welcome to the Wall Street Casino.

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