Profits And The Stock Market ... And The Role Of The Federal Reserve

 |  Includes: DIA, SPY
by: John M. Mason

First quarter profits are coming out. Expectations are not great for the first quarter results. The Financial Times reports:

"Analysts forecast that earnings for America's 500 largest public companies will grow only 0.7 percent for the first quarter, compared with the same period a year ago.

That is a sharp drop from the 7.7 percent expansion posted during the final quarter of last year, according to S&P Capital IQ. Only six out of the 10 major sector groups in the S&P 500 are expected to show earnings' growth."

Thomas Reuters has projected U.S. earnings growth to increase by a "fairly modest" 1.5 percent. But, according to Jim Reid, a macro strategist at Deutsche Bank, "A little more concerning is the fact that over 100 companies on the S&P 500 have provided negative earnings guidance for the first quarter so far, compared to 23 positive pre-announcements." See "U.S. Equities Overcome Early Caution".

Still the stock market improved. The Dow Jones Index closed at a new high of 14,673.46. The S&P 500 reached a high for the day of 1,573.86 but closed down at 1,568.62, just a little below the closing high of 1, 570.25 hit on March 28.

The Financial Times article concluded that "Wall Street investors managed to shake off an early bout of earnings-related caution and push the S&P 500 to within a whisker of a record closing high, as the prospect of continued central bank liquidity prompted investors to once again 'buy on the dips'."

But earnings are an important part of the picture and if earnings don't grow then there is little support for rising stock prices with the exception of a Federal Reserve driven rise in stock prices. I have recently argued that we are in a sideways stock market and without some improvement in corporate profits there is little to support higher stock prices except for "continued central bank liquidity."

Already, some measures of stock market performance are showing that stock prices are high relative to earnings. But, in an expanding economy, stock prices always rise in advance of earnings because the expectation is that earnings will eventually catch up with stock prices.

Yet, we don't see that happening yet in the United States economy. Economic growth is expected to remain tepid, and, as a consequence, corporate earnings are expected to achieve modest growth at best. Analysts keep identifying "green shoots" here and there … but they have been seeing "green shoots" for four years now.

And, according to the Financial Times article mentioned above, "The Dow Jones Transportation Index, often considered a barometer for the economy and the trend of the broader market, has dropped 3.4 percent since the start of the month." Goods are apparently not being shipped and delivered at a very rapid pace.

Which leaves us back to the Federal Reserve and its policy of quantitative easing. The Fed is trying to get something going and it continues to pump reserves into the banking system in an attempt to "jump start" just about anything.

As a consequence of this action, some investors, according to the Financial Times article, see a few bright spots, including a rebound in car sales, improvement in the housing market, share buybacks and a rebound in M&A activity. These are areas that seem to have been somewhat responsive to the actions of the Federal Reserve.

These are areas that I have been writing about over the past few months. For example, there has been action appearing in subprime auto asset based securities, or, the improvement in the housing market, or, the use of share buybacks, or, the rebound in M&A activity.

All of these areas are evidence that the Fed's efforts are pushing money into different areas of the economy, and that seems to be what the Federal Reserve is really trying to achieve. But, two things seem to be happening. First, the funds the Fed is pumping into the economy do not seem to be going into economic growth. The money seems to be staying more in the financial circuit and does not seem to be leaking to any degree into the "real" or productive side of the economy.

Second, the beneficiaries of the Fed's efforts seem to be helping the wealthy more than anyone else. The wealthy have learned over the last fifty years of credit inflation created by the Federal Reserve and the federal government just how to play the system. And, they have the hedge funds, the private equity funds, real estate firms, and ''alternative finance" organizations play the system. And, it is in the "bright spots" mentioned above that they are making a killing.

There has been some movement in other areas. For example, David Bianco, U.S. strategist at Deutsche Bank, tells the Financial Times in the article mentioned above, "Capital markets activity has been picking up, as has capital expenditures."

This gets us to the Wall Street Journal article, "Easy Money: Fed Policies Spur Corporate Spending". The Fuqua School of Business at Duke University and CFO Magazine conducted a survey of 450 CFOs. Of this number, 202 CFOs stated that their companies had borrowed money in the last 12-18 months because of the low interest rates. Fifty percent of the respondents stated that they used this money to increase capital investment. This is the good news.

However, this means that fifty percent of the respondents did not use the money for capital improvements. Over a fourth used the money for mergers and acquisitions; 14 percent increased their cash holdings, 13 percent bought stock back, and 12 percent paid or increased the dividends that they paid. Lots of the money stayed in the financial circuit!

Real economic activity does not seem to be expanding rapidly. A large amount of the money the Federal Reserve is pumping into the economy seems to be going for just financial purposes. How can corporate profits rise in such an environment?

So, the stock market may go up. And, why? Well, the good advice here is "Don't fight the Fed". If the Federal Reserve wants to flood the financial markets and create "unintended consequences", go with the flow. That is what the wealthy are doing.

So, the stock market may go up … and profits may stay relatively flat. There is money to be made but it may not have little or no connection with better economic times.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.