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The Stock Market Warnings: Part 3 of 3

Posted by kdadmin on July 6th, 2015.

The Stock Market Warnings: Part 3 of 3

By looking at just the last five years, of the graphs in Part 1 and Part 2 of this series, The Stock Market Warnings, you get a much clearer sense of the relationship between the PE Ratio of the S&P 500, the price of SPY (an ETF that tracks the S&P 500), and the Federal Reserve’s Quantitative Easing program. I drew the green line to help illustrate a relative trajectory of SPY’s price trend.

Notice anything?

How about the impact that quantitative easing has had on both the PE Ratio and the price of SPY? Notice how they seem to move in lock step? So, what happens now that Federal Reserve has ended its quantitative easing program?

Look at the green line. What’s already happening? Since late 2014, SPY has been unable to overcome its plateau. It’s essentially been flat since January, 2015. Now, it’s trending down, even though the fundamentals are good. On Thursday, unemployment went down, job growth was strong, but the market still finished down. No doubt that the Grexit (Greek + Exit from the EU) has a something to do with it. But we’ll cover that in another post.

Given how close the PE Ratio and the price of SPY have been tracking the level of quantitative easing, it doesn’t take a rocket scientist to figure out that the trend is likely to continue. If you read Part2, you’ll remember why an investor is unlikely to accept a PE Ratio much above 27, would be bargain hunting at 13, and accepts the historical average around 16-18. If not, read it first.

Simple math tells us that as a ratio, the PE Ratio is calculated by dividing price by earnings. The calculation looks like this: Price / Earnings = PE Ratio. Remember basic algebra? We’ll use the concept, X / Y = Z, to define more useful ways to look at the PE Ratio.

  1. Price / Earnings = PE Ratio
  2. Price = Earnings * PE Ratio
  3. Earnings = Price / PE Ratio

If you’re dyslexic, you hate me right now. My apologies.

We’re going to focus on # 2 above and we’ll assume that investors have a constant PE Ratio target. If Price = Earnings * PE Ratio, then earnings become a VERY important part of stock prices. Anything that would have a negative effect on earnings would have a negative effect on stock prices. Enter the end of quantitative easing.

One of the primary goals of quantitative easing was to reduce the cost to borrow money. If you’re a company with substantial debt, the cost to borrow money has a direct impact on your profitability, and, by extension, your earnings. All other things being equal:

  • If the cost to borrow money goes down (2010-2014), your earnings and stock price go up.
  • If the cost to borrow money goes up (2015), your earnings and stock price go down.

We’ll cover the historical impact of the changes in the Federal Funds rate in a later post. But, suffice it to say that the Federal Reserve has indicated it will likely start raising this rate this fall. The operative word here is START. As in, “They are going to continue to increase it.” In other words, “They are going to continue to negatively impact corporate earnings.” In other, other words, stock prices will likely go down over time. This is how the market works.

Now, does this mean you cling to pandering ideas like “investing for the long haul” and turn a blind eye to The Stock Market Warnings? Or, do you face the facts of quantitative easing and PE Ratios,then actually do something about it? While some investors prefer the thrill of playing Musical Chairs with investment asset classes as they wait for the Fed to raise the Federal Funds Rate, I don’t want to be caught without a chair when the music’s over.

So, what does all this mean for your portfolio? In our next post (Wednesday), we’ll consider the risk, the impact of these principles, and what it means for your portfolio. Stay tuned.

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