Bears, Bulls & Bubbles

The Federal Reserve

LONDON-- With major global markets at five and a half year highs, and the FTSE 100 at its best for 13-years, investors and the rest of us are left wondering whether this new level of economic growth is real, or if we are creating a bubble on the way to another 2008-style crash.

The pessimistic analysts and investors, our ‘Bears’, argue that today’s price-to-earnings ratio (a company’s share price divided by the amount of profits it makes for each share in a 12-month period) suggest investors lack confidence in the sustainability of earnings growth and don’t trust this rally. The basic problem, as John Authers notes in the Financial Times, is that since September 2011, “global earnings per share have been flat”.  This indicates, he says, that investors are willing to pay apparently high prices because they expect earnings growth to improve. Their optimistic counterparts, our ‘Bulls’ counter that the price-to-earnings ratio imply stocks are valued fairly and have further room to run.  
Perhaps we should heed the Bears warnings, however, as the S&P’s spectacular average annual return of 26.2% since bottoming out in March 2009, more or less mimics what happened ahead of the tech-stock-bubble-burst in 1999, which erased more than $5 trillion in stock-market value.  
Lee Adler of the Wall Street Examiner argues that there is no real connection between profit margins and share prices in any case, saying that the apparent correlation comes as they are both influenced by monetary policy. When central bank policy is loose, profit margins expand (because people are buying more) and share prices go up too. When central banks are tightening, people stop buying as much, and earnings go down – along with share prices.
Maybe this is why the Bulls feel that markets have room to move up further.  After all, the Federal Reserve has provided an unprecedented level of support for the past five years, keeping interest rates near zero percent, while pumping $2.3 trillion of economic stimulus into the US economy.
But taking a Bears-eye-view of the Fed’s quantitative easing policy might add weight to their arguments, as the Fed has explicitly said in the past that it wants to drive share prices higher – partly to make people feel wealthier and, happier to spend their money.  I won’t argue with you if you think that seems like a back-to-front way of getting more money into the economy, but it seems the Fed is willing to do whatever it takes to persuade people to start spending again.
So who has it right – the Bears or the Bulls?  Only time will tell, but as long as the money-printing presses are running, markets can probably go higher. The flipside, as Adler notes, is that “when central banks pull the plug on the money printing, stock prices will come back down, hard, regardless of what profits do.” 
Most feel that the Fed will not pull back until the economy is stronger, which means that the loose monetary policy will continue to prompt markets higher for a while longer yet.

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