Michael Pollaro writing at Forbes.com reexamines the implilcations of the ending of Quantitative Easing policy by the Federal Reserve: “The lion’s share of the supposed economic strength we see today is both artificial and unsustainable because it is built on malinvestments born out of the monetary largesse underwritten by the Federal Reserve’s policies. Normalize those policies; i.e., end QE and raise interest rates, and sooner or later those malinvestments will be liquidated. The supposed economic boom will turn to economic bust, and with that, a bust in the publicly traded equities that lay claim to those malinvestments.”
Looking through the lens of ABCT, the dynamics here can be explained thus… For the past five-plus years, emboldened by the near zero interest (discount) rates fostered by the Federal Reserves, continually cashed-up investors and speculators have been bidding up the price/value of all financial assets, driving a wedge between the value of those assets as priced in their respective markets and their true value based on properly discounted, expected future cash flows.
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Now, in our minds, nowhere is this wedge greater than in the equity market. You might say wait a minute. Where’s the wedge? Don’t most broad-based market PE multiples – like the roughly 16 handle on the 12-month forward multiple of the S&P 500 – say otherwise? Have not company per share earnings been growing, especially recently, right along with equity share prices? Yes, but what strikes us is the reason for a good portion of that earnings growth; namely, it’s a function of the same swathe of money that has inflated equity share prices. We point to the unprecedented deluge of financial engineering programs orchestrated by company CEOs – refinancing tactics, stock buybacks, dividend hikes and of course M&A – financed off the back of the Federal Reserve’s QE purchases and ZIRP policies.
So, when might this wedge in the equity markets be filled? Well, in accordance with ABCT, it will begin when the monetary largesse that is currently feeding the equity market boom (and financial engineering boom) abates. Could that be when the last vestiges of QE3 work their way through the financial markets? Or will it have to wait until the Federal Reserve begins raising rates? Perhaps the banking system will fill the void being left by the Federal Reserve with its own swathe of money creation? Maybe some cross-border capital flows coming from European investors could help fill that void too? Indeed, could the Federal Reserve fill the void itself with QE4. These are tough questions, ones we will be examining in future posts.
