When I read Paul Krugman’s op-ed, Bull Market Blues, I realized I had at least three ideas that explained the bull market blues better than his idea that “stock prices reflect profits, not overall incomes”. Here are my top three ideas.
Federal Reserve’s Co-dependent Relationship With The Stock Market
By far the biggest impact on stock prices has been the question of when will the Federal Reserve stop its zero interest rate policy. To buyers and sellers in the stock market the latest speculation about the Federal Reserve decision is far more important than either actual profits or profit guidance. Almost every week there is a financial reporter saying the market has gone up or down based on speculations about Federal Reserve actions. This link is stronger now than at any time in the history of the Federal Reserve. After seven years a large group of buyers and sellers have cynically embraced the thought that the zero interest rate policy has created a stock market bubble and is the only thing holding up higher stock prices. Although the Federal Reserve loathes to admit it, it is their fear of declining stock prices that caused their policies to devolve into this co-dependency relationship. Now they are stuck with a policy that can written off as “trickle down economics” for banks but is increasingly necessary to keep the stock market bubble intact. It reminds me of the Federal Reserve easy money policies during the 1920s and we know how that stock market bubble ended. There is nothing that gives me the blues more than to see how quickly the Federal Reserve backs off of a rate increase when the stock market tumbles for a couple of days. It is as if the Federal Reserve cares more about the stock market than the economy. At some point the Federal Reserve will regain its focus on the economy and all of us will have to endure the stock market blues until we can purge the market of its excesses.
The FANG Portfolio
In 2015 the S&P 500 would have declined if not for the FANG portfolio, Facebook, Amazon, Netflix, and Google. Despite Mr. Krugman’s belief that stock prices reflect profits these companies are prime examples of growth stocks that are richly valued by their expected profit growth and not their minuscule profits. They also represent the leading edge of the Unicorn Companies who have rich valuations and almost no earnings. To paraphrase former Federal Reserve chairman, Allan Greenspan, there seems to be an irrational exuberance for these unicorn companies. As an example of this irrational exuberance, Salesforce.com has almost never had a profitable quarter and presently sports a price to earnings ratio of -4,213. How does this company deserve a market capitalization of $54 billion and get its name on the tallest building west of the Mississippi?
One of the interesting trends since the last economic expansion that was based on productivity gains has been the growth in financial engineering tricks. Since financial engineering was one of the technologies that enabled the sub-prime mortgage bubble and the 2008 stock market crash, it is foolish to overlook its importance. Despite reforms from the 2008 crash financial engineering remains largely intact, profitable, and does not require many people to implement. To many companies it is more attractive than investing in productivity improving ideas such as direct capital expenses and employees. It is also one of the main reasons middle class wage increases have stagnated since 2000. In its most recent incarnation many companies have taken advantage of low interest rates to buy back their own stock in an effort to raise their stock price. The executives and stock holders of these companies realize they will be rewarded with higher stock prices despite the fact the sales for the company are unchanged. If the best investment idea for these companies is to buy back their own stock, it is also a condemnation of these executives whose primary job is to grow sales and reduce costs via new products, greater innovation, and productivity. The worst case scenario is that one of these days the Federal Reserve will be successful at creating higher interest rates and inflation and these companies will have too much debt to invest in new products and productivity improving ideas.