QE3 creates a new challenge for investors
“Look, up in the sky. Its a bird. Its a plane. No, its Super Ben.” The market is at its highest level in more than four years—up 14 percent for 2012. By many measures this is the best year since 2003. So where does the market go from here? Can Super Ben, i.e. Federal Reserve Chairman Ben Bernanke, save the economy and the market? Facing an array of fundamental challenges, “Super Ben” faces a difficult problem. The challenge for investors is daunting.
Fundamental Challenges
Presently, the S&P 500 is trading at 13.3 times its forward Price Earnings (PE) estimates, close to the upper range of the last 5 years. The median forward PE ratio has been 12.9 over the same period, meaning the market is close to being fully valued. Granted this is slightly below the median forward PE ratio of 13.7 since 1976 per Morgan Stanley. According to Yale economist, Robert Shiller, earnings per share for the S&P 500 grew at a 3.8% annualized rate between 1874 and 2004. Since 1980 real earnings per share growth has been 2.6%.
In the September 3, 2012, Barron’s cover story titled, “Tough as Teflon,” 10 market strategists gave profit forecasts for the S&P 500 ranging from $100 to $105 for 2012 and a mean profit forecast of $107.37 for 2013. This comes in the face of evidence of weakening economic news from the U.S., Europe and Asia.
FACTSET, a site for professional investors, is now showing a blended earnings growth rate for the third quarter of 2012 of -2.9%. Energy (-23.6%) and Materials (-19.8%) expect the lowest earnings growth rate for the quarter reflecting the trouble in Europe and the slowdown in Asia, especially China. The highest growth sector is the Financials expecting earnings to grow by 8.1%, assisted by QE3.
FedEx Corp has cut its profit outlook for the current quarter citing the weakness in the global economy was negatively affecting overnight shipments globally. Intel Corp followed by cutting its third-quarter revenue estimate indicating lower sales of personal computers by Hewlett Packard and Dell Inc was hurting demand for chips.
Iron ore accounts for approximately one-third of all sea-borne volume. Spot iron ore prices continue to trend down after reaching a high in January 2011 as demand from China slows.
In addition, the rates for ships carrying dry commodities as measured by the Baltic Exchange Dry Index continues to trend down reflecting falling demand for many commodities.
In the same story in Barron’s, forecasts for the 10-year Treasury ranged from 1.5% to 2.4% with 2.0% being the most common. Yield on the 10-years were about 1.57% at the time. Forecasting higher yields indicates that the economy would strengthen. Yet now, only a short time later, the Federal Reserve announced another round of quantitative easing (QE3) after their two day meeting. In Fed Chairman Ben Bernanke’s speech at the annual monetary policy leaders meeting in Jackson Hole, Wyoming, he stated the economy “is obviously far from satisfactory” and the weak job market is a “grave concern.”
Each of the events above point to a weak recovery at best with a recession as a possibility. So to repeat, “Look, up in the sky. Its a bird. Its a plane. No, its Super Ben.” Will the Fed’s quantitative easing moves fix the economy and sustain the rally?
Don't Fight the Fed
Quantitative easing means the Federal reserve will take actions to provide additional money into the economy by buying securities. By doing so they force interest rates lower in the securities they acquire. This action counters the forecast that rates on 10-year Treasuries would rise. Looks like the analysts were wrong.
In the previous two quantitative easings, the stock market responded positively as the new money found its way into stocks fueling rallies. QE1 funneled $1.7 trillion into the economy, while QE2 contributed about half a trillion.
The latest QE3 is a different beast. Rather than state how much and by when the Federal Open Market Committee intends to buy $40 billion in agency mortgage-backed securities per month. There is no time nor dollar amount on this program.
The Committee intends to make these type of buys and other necessary action “until such improvement (in the labor market) is achieved in the context of price stability.”
Essentially the Fed is pumping in more money into the economy. More money means assets will increase in value. Stocks, gold, oil and many other assets will go up in value, though the dollar will fall.
The Bottom Line
Stock markets rallied following QE1 though the market was severely depressed. QE2 helped the rally to continue. Now that the market is reaching higher levels, it might be more difficult for the rally to continue.
You do not fight the Fed. This unprecedented move will lead to further escalation in assets including stocks despite a weak economy and a distressed labor market. Stock markets will make new highs but the value of what investors own is based on a false premise. The Fed’s action will inflate assets and stocks though it will not correct the fundamental problems facing the economy. At some point the market will catch face up to the truth. Until then investors should remain invested with their finger over the sell button.
