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How the Market Works

Profits Before Prices – How the Market Works

Posted by kdadmin on June 7th, 2016.

Profits Before Prices – How the Market Works

The price of a stock is directly related to the amount of earnings (revenue) it can generate per share. The end. The only reason we buy stock is to participate in the earnings of a company without having to run that company. The ONLY REASON.

Now, maybe you like the company’s products or their social agenda or the colors on their boxes. But if that company can’t produce a profit, in which you can share, you have no reason to invest your money with them.

Look at the chart above. What do you notice about corporate profits (the orange line) inside of each of the black circles?

Profits BeforePrices

Did you notice that corporate profits are NOT going up? Rather, in each of the black circles above, corporate profitsare either level or declining over time. Now, look at the stock market prices (blue line). Notice what happened to the stock market in 2007 when corporate profits began to flat lineand then fall. They plummeted.

But what about in 2012, when corporate profitswere flat but prices continued to rise? Notice the Federal Reserve’s Quantitative Easing process (the red line). Notice how the Feds pumped easy money into the financial system and how the stock prices shot up in lock step with the amount of money the Fed lodged into the finanial system.

Throwing Gas on aFire

The Fed’s Quantitative Easing process is akin to throwing gas on a fire. It creates an immediate fireball, but doesn’t last very long. By pumping lots of money into the financial system, the Fed gave businesses the ability to borrow huge sums of money at very low costs. Which, in turn, led to their ability to hire lots of people and make profits at on a large, but not increasing, scale.

Herein lies the key.
Notice how after stock prices caught up with corporate profitsin 2014, stock prices have repeatedly returned to the that level? This is because the Fed’s Quantitative Easing process can drive up stock prices, but not forever, because corporate profits are not organically increasing. The market is only so big. There are only so many consumers buying things at a so fast apace. There is a limit to how much the Fed’s free money policy can drive up prices.

We are at that limit.
In fact we have been since the Fed stopped buying bonds in late2014 and started raising rates in 2015. As soon as the Fed stopped propping up the market,and corporate earnings remained flat, stock prices began to drop.

We All Know What Happens Next

As the Fed increases the pace that it removes money from the market system by not buying more bonds when older ones matureand through interest rate increases (the red line goes down), the ability of corporations to make profits on huge amounts of free money drops, because demand stays relatively level.

And when corporate profits drop, so do stock prices.

Given that the Fed’s Quantitative Easing has pushed stock prices to levels far beyond reason (they should have stopped in 2012), it’s likely that corporate profits, and thusstock prices, will fall sharply and painfully. In other words, August 2015 and January 2016 were warning shots.

What You Can Do About It

Stay out of stocks. Buy bonds. Learn about which bonds in this article, “One Year Later, Bonds are the Winner: How the Market Works.”

Remember, having plenty of money in cash and other defensive investments can set you up for great opportunities when the market tanks and others are selling out at the bottom.

This is what we did in January, and it paid off handsomely. You can learn about that here.

We’re going to try to do it again. Would you like to join us?

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