Common stocks should be simple investment instruments. A share of stock represents ownership of a business. If that business makes more money (bottom line profits or earnings per share) eventually the stock should increase in price. If the business can’t grow its profits, eventually the value of the company will reflect this fact and decline.
Large public companies like those on the Standard and Poor’s 500 Index employ accounting loopholes that add complexity to the earnings analysis process. After they sell their product and generate revenue their cash flow can be diverted and accounted for through a labyrinth of rules and regulations that provide the company with ample opportunity to obfuscate the trends in their underlying business. Google, Apple and other large companies keep much of their overseas profits in foreign accounts to avoid paying U.S. corporate income taxes. In July some of the biggest banks in the country announced profits that exceeded estimates only to acknowledge that the only way the beat expectations was to recapture profits that they earned in previous years through legal (but liberal) accounting rules.
None of this is new and investment analysts have learned how to grapple with these vagaries. Investors do have a new mystery to unravel and the stakes are higher than ever.
In an unprecedented move the Federal Reserve has added 85 billion dollars of artificial stimulus to the economy every month since December 2012. To put this 680 billion dollar stimulus into perspective it’s helpful to understand that the annual profits of the top 10 Fortune 500 companies are only $176 billion combined.
It would be laudable if this stimulus helped create jobs, higher wages or pay down debts, but all it has succeeded in doing is temporarily inflate stock prices and allow every major corporation to lower their borrowing cost through historically low interest rates.
Stock investors know that this massive stimulus is responsible for pushing stock prices up and even Bernanke has been transparent about this fact. Stock prices become less transparent when you begin to subtract this from their valuations. What will interest rates do? What are stocks worth without the heavy hand of the Fed intervening on Wall Street’s behalf?
Bonds and stocks dropped from May to June on the unexpected news that the Federal Reserve would begin to reduce the stimulus later this year. The market reaction to the thought of life without Quantitative Easing is telling. Coupled with a growing list of statics depicting broad based weakness in the economy, we interpret the tapering of the Fed stimulus as a “sell on the rumor, buy on the news” stock event.