The Fed is Crashing Stocks... On Purpose

Written By Briton Ryle

Posted February 15, 2016

We all know that the Fed’s monetary policy is the single-most important catalyst for stock prices. Yes, earnings and dividends matter. Without solid earnings growth, there’s no reason to own stocks. But if you want to see valuations expand — that is, get price-to-earnings ratios higher — the Fed is your best bet. 

It’s pretty obvious that the Fed’s monetary policy over the last six years has been good for stock prices. And from that perspective, now that the Fed has raised interest rates a quarter point, stock prices have suffered. Yeah, I know, you wouldn’t think that a measly quarter-point hike for interest rates would send the stock market spiraling down 12%, but that’s what’s happened…

Now, before I get to the meat of this article, I want to address the price-to-earnings (P/E) valuation metric quickly. A P/E ratio is the most popular way to determine the value of a company. It effectively ignores the actual stock price and instead tells you what the company’s earnings per share is worth. To calculate a P/E ratio, you simply divide a company’s stock price by its earnings per share.

For instance, if a company’s share price is $20 and it earns $2.00 per share, then the P/E ratio is 10. It may be helpful to think of it in terms of buying the company. Say you bought out the entire company for $20 a share. That P/E ratio of 10 tells you that you could pay for the acquisition out of the company’s profits in 10 years. Sounds like a pretty good deal, right? That’s why the average historical P/E for the S&P 500 is closer to 17.

P/E ratios tend to rise when interest rates are low. And that’s actually a pretty reasonable reaction. Because when money is cheap, the cost of doing business is lower, and therefore profits should be higher. If profits are growing, then it will take you less than 10 years to pay for that $20-a-share company.

But of course, you can count on the fact that what starts as reasonable will get unreasonable pretty quickly. After all, these are humans we’re talking about…

The Madness of Crowds 

I’m not going to tell you there aren’t rational people out there. I’m sure there are somewhere. But by and large, humans are crazy.

And therein lies the irony of economists, especially those who have achieved the highest throne of economist-dom (i.e., Fed governors): they actually think they are scientists. They believe that just because they can measure economies, they can control them. Ha! Again, these are humans we’re talking about…

The one thing you can count on is that we humans will take things to an extreme. 

So it’s kind of pathetic when the Fed seems surprised at the reactions to its monetary policy. I mean, did they really think investors would take zero interest rates in stride? WHEEE! FREE MONEY! BUY, BUY, BUY!!

Just a month or so ago, the P/E ratio for the S&P 500 was over 20. At the same time, China was slowing, oil was cratering, emerging markets were getting crushed, earnings were weakening, GDP growth was weak, and so on. The ONLY positives were employment growth and the Fed.

The last Fed Chief, Ben Bernanke, was all about stock prices. He wanted them higher and he paid around $3 trillion to get them there. And investors were more than willing to oblige…

But our new Fed Chief, Janet Yellen, is no Ben Bernanke. She’s trying to be rational. Gulp…

Meet the New Boss

We should have seen this coming. Back in May, Yellen said, “I would highlight that equity-market valuations at this point generally are quite high.” 

If you ask me, Yellen raised rates for one reason only: to push stock prices down. Why do I think that? Well consider these excerpts from her testimony to Congress the other day:

…low commodity prices could trigger financial stresses in commodity-exporting economies, particularly in vulnerable emerging market economies, and for commodity-producing firms in many countries. Should any of these downside risks materialize, foreign activity and demand for U.S. exports could weaken and financial market conditions could tighten further.

Does that sound like an environment where higher interest rates are appropriate? What about this one:

…the recent further declines in the prices of oil and other commodities, as well as the further appreciation of the dollar, the Committee expects inflation to remain low in the near term.

So the Fed says it wants higher inflation. And it acknowledges that a stronger U.S. dollar will keep a lid on inflation. Raising rates strengthen the dollar, so…

Now here’s Yellen’s official rationale for raising interest rates: 

The FOMC conducts policy to promote maximum employment and price stability, as required by our statutory mandate from the Congress… If the FOMC delayed the start of policy normalization for too long, it might have to tighten policy relatively abruptly in the future to keep the economy from overheating and inflation from significantly overshooting its objective.

That’s all well and good. But later, in the Q&A part of her testimony, she said the following, and I have to paraphrase, because I’ve been unable to dredge up the exact quote. Yellen said that the recent stock market declines have brought equity prices more in line with historical averages. 

Yikes. This tells me that Yellen is actively trying to manage stock prices by raising interest rates. And look how well that’s gone. Something like $1.2 trillion has been erased from the stock market this year. The S&P 500 is back to where it was at the end of 2013.

Let’s hope she doesn’t hike rates again anytime soon, or we might see some new definitions of irrational. 

Funny thing is, she may have already achieved her goals for lower stock prices. It took Ben Bernanke $3 trillion to get a six-year bull market. Yellen just erased one-third of that bull market with one quarter-point rate hike. Irrational? You tell me…

Until next time,

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.

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