How The Fed Directly Subsidizes Corporate Profits And Why The Game Is Over

Includes: IWM, QQQ, SPY, TLT
by: Nicholas Pardini

I admit I have been early on calling the end of the "Fed bubble" as price action has continued to rise further than my greatest expectations. However, as the market has risen, the quality of economic data has deteriorated. Like every other central bank created asset bubble, this time is not different and stocks will correct back to at least pre-QE 3/4 levels.

Those who are bullish on equities often argue that this current rally is sustainable without the Fed due to record high corporate profits. Their logic continues with the idea that the Fed cannot use QE to drive up profits directly. The reality is they can and do. By providing cheap credit for the federal government, the Fed effectively subsidizes earnings.

Quantitative easing boosts earnings by making massive government deficits and social spending affordable. The state effectively replaces large corporations as the supplier of income to consume the products that drive revenues. Earnings have maintained high levels due to companies being to cut jobs without losing much revenue from customers. Since those who live on government benefits likely earn less than during their time working, revenues have stagnated. Population growth and the fact that the government through food stamps, extended unemployment insurance, Obamacare, disability claims, and other welfare has replaced corporations as the supplier of income has prevented revenues from declining.

Government dependency has reached the point where 41.3% of Americans receive more from the state than they pay in taxes. If government employees are included, this number likely exceeds 50% of the American population. The government is effectively subsidizing corporate profits by providing income for customers to still consume without companies needing to create jobs to earn that income. Since, Americans in the private sector do not earn significantly more than their government counterparts, there is no long-term way to pay for all of this social spending.

Outside of government dependency, the Fed also juices up profits through allowing large companies to refinance their debt at extremely low rates. This not only reduces interest expenses but also encourages companies to leverage up to buy back shares. This works well in the short term, but increasing indebtedness has weakened corporate balance sheets. An early sign of is the escalating S&P 500 debt/equity ratio of 1.55 (57% higher than historical averages).

Overall, the Fed has been directly responsible for record high profit margins by the combination of allowing income to be detached from employment and slashing interest expenses. When the US has debt of over 100% of GDP and pays out 12% of the budget in interest payments in a record low rate environment, this subsidizing of profits is not sustainable. The direction of the economy and lack of real income will force capital markets to revert to lower valuations. Even if earnings just decline 10% from here to $91 on annualized basis, and the P/E ratio falls to a reasonable but not cheap level of 12, that prices the S&P 500 at 1092. Stocks can fall much further than that if earnings decline more or if the P/E ratios fall at the level of historical bear market lows in the 7-10 range. Outside of an unlikely inflationary collapse of the dollar, I do not see any way that this market does not revert back to prices implied by current economic fundamentals.

The trade here is to short US equities (SPY, QQQ, IWM) as the support from the welfare state and the Fed will erode. The downward catalyst will either be fears of a reversal of the current monetary policy or a declining economy despite the Fed's efforts pulling down earnings even further. Bonds (NYSEARCA:TLT) should also perform poorly as fear about the US government's creditworthiness and/or declining Fed will trigger higher rates. This was exemplified by ten year yields shooting up 0.08% in spite of risk assets such as stocks, commodities, and foreign currencies, selling off.

Those who quote "don't fight the Fed", should look at what is happening in Japan with the Nikkei imploding overnight and JGB yields skyrocketing as investors start to see through Abenomics as a policy just to keep the government afloat versus improving the real economy. What the rest of the world's central banks are doing is not much different. That eye-opening moment will happen soon with the Fed as well and both stocks and earnings will sink as reality grips investors. The technical engulfing candle during Wednesday may have been the blow-off top that ends this rally once and for all.

Disclosure: I am short SPY, QQQ. 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.

Additional disclosure: I am also short Japanese government bonds.