The Federal Reserve’s reflation of the stock market to record valuations appears complete. The S&P 500 was down 12% in March. It finished April up 12%. But as you can see from the chart below, the forward price/earnings ratio on the S&P 500 is HIGHER now than it was when the index peaked in February.
The chart also shows the correlation between the increase in the Fed’s balance sheet – over $2 trillion since March – and the S&P 500’s forward P/E. This is pure multiple expansion – paying more for the same (or declining) earnings. And it’s directly related to the Fed pumping liquidity into the financial system.
This liquidity has utterly failed to stimulate Main Street. But it’s hard to believe stocks have gotten more expensive after a record crash in March. The Dow Jones Industrials had its best April since 1987. It was up 11.1% for the month. At one point, it was up as much as 12.4% – exceeded only by a 13.2% gain in January of 1987 and a 16.3% gain in October of 1974. Why do those dates matter?
The move in 1974 was the end of a bear market. Stocks came roaring back. The 1987 move was an outlier. The crash later that year wiped out 22.6% in one day.
The bear market rally since the March lows came faster than expected. Algos and ETFs have made everything faster.
Forward P/Es will blow out even more as the earnings picture for the second quarter emerges. Recent price action was bearish because even companies like Amazon and Apple – the mega cap Big Tech darlings of this market – driving some 20% of the index, and, by extension, the index funds – reported pressure on earnings in March. And remember, that was just the tail-end of the first quarter. Two weeks. Amazon’s sales were up 26% but its net income fell 31%.
The Dow-to-Gold ratio sits at just above 14. If the Fed is lucky, its balance sheet expansion might be able to send stocks higher. But this will mean even greater multiple expansion (paying a higher premium on declining earnings). More likely, based on history, is another down-leg in the bear (deflation in financial asset prices and a rising gold price). But who can say, when the Fed has assumed the role of buyer of all…?
The velocity of money goes down in a recession. We discussed this yesterday. People spend less. They save more. They pay down debts. Businesses build up cash buffers. That’s where we are now. And that’s why the huge increase in the Fed’s balance sheet has caused asset price inflation but NOT consumer price inflation.
While Wall Street swims in liquidity, vanishing cash flows have created a solvency crisis for millions of small businesses. The government, through the Treasury, will be under enormous pressure to increase cash handouts to businesses and the unemployed. There are three serious initiatives being considered to continue handouts and bailouts. Trillions of fake currency units soon to be released…
What could possibly go wrong?
Jeff.W, Guest blog
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