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Friday, February 28, 2014 recorded a new record for the S&P 500 index. And the index is up almost 23.0 percent, year-over-year.

Can this gain be sustained?

Since the near-term trough in 2009, the S&P 500 has followed a relatively jagged yet upward trend. At the end of 2010, the index was up 12.0 percent year-over-year; in 2011, it was up only 0.2 percent; in 2012, it was up almost 13.0 percent; and at the end or 2013, it was up almost 29.0 percent.

The problem that many analysts point to in this picture is that corporate profits have not kept up with the increase in the stock prices. Since December 2010 until December 2013, the S&P 500 rose by almost 50.0 percent. During this same time period, the earnings of the S&P 500 companies only rose by about 22.0 percent.

That is, the price/earnings ratio of the S&P500 index rose.

To get away from some of the short-term movements in stock prices, many analysts use the measure created by Robert Shiller called the Cyclically Adjusted Price Earnings ratio or CAPE. In December of 2011 CAPE was at 20.52, substantially above the historical average. This point is important to Shiller because historically, CAPE always tends to return to its mean, although the timing of this is never certain, and can take a long time to achieve.

Recently, CAPE has been over 25.0, about a 23.0 percent increase, taking it to a near-term peak, although not as high as it has been in the last six years.

Often in an economic recovery, stock prices will rise in anticipation of rising earnings. That is, under this scenario, CAPE will fall over time as earnings rise to meet investor expectations.

The question in the current time period is whether or not the earnings will rise sufficiently in this economic recovery, something that many suspect will not happen because of the weakness of the growth experienced since the expansion began.

Real economic growth was higher in 2014 than in the past two years, but coming in at only a (revised) 2.5 percent year-over-year rate of growth, this is not such a stellar performance. Some analysts, including myself, believe that economic growth in 2014 may rise to around 3.0 percent, but even if the economy does reach this rate, the whole recovery that began in July 2009 has been tepid, at best.

Nominal GDP growth has only average slightly more than 4.0 percent, year-over-year, in the past four years.

It is no wonder that the growth in corporate earnings has not been at a much greater year-over-year rate than this during the recovery. And, the truth is, that if earnings growth does not pick up, CAPE will not be coming down because of future earnings growth.

The only financial figure that has risen close to the earnings growth has been the rate of growth of the M2 money stock. From December 2010 to December 2013, the M2 stock of money rose by 25.0 percent. Earnings of the S&P 500 companies rose by 22 percent. Is there a connection? Maybe…maybe not.

Stock prices, as mentioned above, rose by almost 50 percent during this time period. What will keep stock prices at or near current levels?

If the real economy only rises by about 3.0 percent in the next year and even if it reproduces that performance in 2015, in my mind, earnings growth will nowhere near produce earnings that will match up with the level that stock prices have achieved in the previous year or two.

Thus, it seems to me, that we must look elsewhere for the justification of these stock prices. And, the only place that seems reasonable to look is economic policy… especially monetary policy.

Yes, the Federal Reserve is tapering its purchases of securities from the open market. According to the testimony of current Federal Reserve Chairwoman Janet Yellen, the Federal Reserve will continue to taper purchases of securities throughout 2014… unless economic data seem to indicate that the economy is weakening or is much weaker than it is perceived to be.

Even if the Fed reduces its purchases by $10 billion every month for the rest of the year until it is purchasing no securities each month, this will mean that in 2014, the Fed will have acquired $320 billion more for its portfolio. Note, that in 2013, the Fed added more than $1.0 trillion in securities to its portfolio.

Given that in 2008, the Fed's balance sheet was only slightly more than $900 billion in assets, $320 billion is still a lot of securities!

The monetary base, the sum of currency in circulation and bank reserves, has risen by 84.0 percent from December 2010 through December 2013. This is huge!

Most of the reserves the Fed has pumped out over the past four years or so are still being held as excess reserves by the banking system. Even though the Fed stops purchasing more securities, the next question is about what is going to happen to all these reserves the Fed has injected into the banking system.

What seems to have happened in the economy these past four years is that the Fed has pumped a lot of funds into the financial system, and these funds have stayed in the financial system. Historically, when the Fed has injected funds into the banking system, a large portion of the money has gone into the production of real goods and services, into economic output. But over the past fifty years of so, the financial community has learned that it can benefit itself by keeping most of the money in the financial circuit and by putting less and less of the funds into the production circuit. Money can be made just as well, if not better, in the financial circuit, as it can in the production circuit.

So it appears as if money is chasing money. Stock prices rise. Hedge funds buy homes, securitize the properties and pay the interest on the debt by the rental payments they collect. And through quite a few other very nice, new financial innovations.

Thank you, Federal Reserve System!

How long can this financial circulation keep going on? That, of course, is the question.

Can the Federal Reserve, when it needs to, "call in" all these funds it has pumped into the banking system? Well, something like this has never been tried before, and it will be a massive task. It seems to me Mr. Bernanke left the scene at a very propitious time.

But back to the stock market. It is hard for me to imagine that earnings in the future will catch up with the current stock prices. However, there is plenty of money around to keep stock prices at or above current stock prices for a long time. The question, as always, is for how long?

Source: Is The New S&P 500 Record High Sustainable?