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How the Market Works

Stock Market Stall: From the Flight Deck

Posted by kdadmin on July 22nd, 2015.

Stock Market Stall: From the Flight Deck

Airplanes operate on the principle of lift. Essentially, the airfoil (wing) disrupts the direction of the flow of air over it, exerting downward force on the air (a fluid). Following Newton’s third law, the air must exert an equal and opposite force on the airfoil, thereby pushing it up (creating lift). For an exhaustive, and painfully detailed, explanation, click here.

Now, for a given airspeed, and angle of attack (the relationship of the chord line of an airfoil to the flow direction of the wind), an airfoil will generate a specific amount of lift. Simply speaking, if the airspeed is too low, and/or the angle of attack too high, the airfoil can stall and lift will drop drastically. This is bad when your plane is 35,000 feet up in the air.

I bring this up because it’s a great analogy for the relationship between the stock market, PE ratios, and the Federal Reserve’s Quantitative Easing program (QE).

Let’s say the stock market price is lift, designated by SPY in the chart above. We’ll call PE ratios the angle of attack, shown as the PE cyclically adjusted ratio above. Lastly, the QE program will be the airspeed, shown by the Fed’s Long-term Treasury purchases above.

As you saw in my three part series, The Stock Market Warnings, the Federal Reserve’s quantitative easing program has been an incredible market stimulus. Clearly, it’s provided the thrust for the market’s direction over the past several years, and has propelled us to new heights. But, it has stopped. So, instead of enjoying an ever increasing airspeed, we’re now a glider.

Further, our PE ratio has increased substantially from about 13 to about 27. In other words, our angle of attack has increased over the past six years. This was fine, of course, when had the escalating thrust of the Federal Reserve’s QE program. But with that gone, our angle of attack is unsustainably high. Instead of an attractive stock yield of 7.7%, we’re now looking at barely over 3.7%, when bonds pay 2.5%. It’s not as compelling to buy stocks right now when you consider the risk.

Aeronautically speaking, our airspeed is too low and our angle of attack is too high. In other words, the stock market (SPY) is stalling. One look at the last section of the chart will tell you that. Since January 1, SPY is up just shy of 2.4%. Whereas over the same period last year, it was up 8.2%.

Does this mean we’re in for a crash landing? Probably. When a plane (its airfoil) stalls, if there is enough altitude, usually the way to correct it, is to reduce the angle of attack on the airfoil, and build up airspeed. This is accomplished by pointing the nose down. It’s the same with market. It’s very unlikely the market will sustain these PE ratios and stock prices in the absence of QE. We’ve already stalled out. The market has been trading in a sideways channel for most of the year. At a certain point, there will likely be some rationalizable catalyst that eliminates the current irrational hope (that the market and PE ratios will go higher), and a correction will follow. While past performance is no guarantee of future results, broad market trends like these can provide very useful reference points. This is how the market works.

So what do you do now? Land the plane. Kiss the ground. Let the storm blow over. Then read my post, Investment Selection: Just Walk Away for more on the next step.

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