The Quantitative Easing Illusion: Fractioning The Dollar, Undervaluing The Markets

by: StockMatusow

On a regular basis, I hear guests on CNBC constantly saying the market is overbought. After awhile, I wonder if these individuals learned about modern finance from a Cracker-Jack box. These same people were screaming at the world in 2008 to buy all the dips as the Dow was heading towards 6500, suggesting to us that the market was undervalued.

Then there was me, who got my family thoroughly out of the markets near the highs of the same year. I saw liquidity drying up, I knew about over leveraging taking place, and the overspeculated housing market that was already well on its way to crashing into the ground.

I'm a High School drop-out who beat these guys and the markets in 2008, and on a consistent basis, I still beat them both. How did I get the call right, when many of these college educated geniuses got it wrong, and generally still get it wrong?

It is because I understand the most crucial core fundamental driver of equity markets, which is access to liquid capital.

The more liquidity in the system equates to more money being moved in and out of stocks, bonds, funds, etc. It's true about Greece; if they have a disorderly default, we would be facing a situation worse than 2008. The ISDA would declare a default, and overleveraged derivative insurance would kick in, possibly at a rate as high as 7 to 1. Instantly, at least 5 major U.S. banks would become insolvent, drying up lines of credit and liquidity. This would dry up the well of capital. These same banks would then engage in selling off all their market positions, taking whatever profits they currently have while simultaneously shorting the pants off the market causing it to crash; This exact issue occurred in 2008.

This also occurred to a far lesser extent in the summer of 2011, when the markets took a sharp downturn on the prospect of a Greek default. What happened then is that their computer systems were programmed to short the market to a point that these institutions could produce enough electronic liquidity, just in case they found themselves on the hook to pay off on the massive leveraged derivative insurance issued to Greece bond holders.

Post crash 2008: The Fed to the rescue

The Fed knew they had to do something, and do something quickly. A government bailout was not going to be enough. Simply bailing out those "too big to fail" institutions would not allow a solution, as liquidity would still dry up. Enter in Quantitative easing, (QE) where The Fed took on "bad assets" in exchange for injecting a predetermined quantity of virtual money/credit into a system drained dry. It's actually not about printing new money; it's more about providing new lines of electronic credit and equitable liquidity to financial institutions who were carrying bad assets/excessive liability. The Fed took/bought the bad assets/liabilities of these institutions in exchange for new lines of electronic credit and equity.

Instantly, many of the ramifications of these bad assets/liabilities were virtually erased, and many financial institutions got a mulligan, all without having to declare bankruptcy, remaining solvent.

Many will simply say the Fed is buying up government bonds, which is only a part of QE, and far too simplistic an explanation.

This process is remarkably easy. The Fed introduces new money into the system by electronically punching in a new number with a bunch of zeroes for financial institutions of their choosing and the problem is fixed, or is it? Actual newly printed money is not being matched up with the numbers punched into the system on a 1 to 1 basis. Only a fraction of what the computers say an institution has in actual greenbacks actually exist on hand, hence the term "fractional reserve banking."

The Fed is not printing up all this new money like many people say they are. They are just allowing banks more leverage in the system which in turn weakens the actual dollar. Think of it this way; in the past, we had a gold standard where every dollar printed was backed with gold. Over time, there just was not enough gold to back up the green backs in the system, as the money printed far exceeded the actual amount of physical gold in reserve. Now, there are not enough actual greenbacks in reserve to cover the actual computerized numbers typed into the credit system. As the computerized numbers inflate and multiply, the actual value of the real dollar is diluted, much like a company that continues to increase its outstanding shares ready to be traded.

As a company continues to add more shares for investors to buy, the actual dollar value of the pps will continue to decrease.

By engaging in QE, The Fed has lowered the value of fiat currency by creating an excess computerized numbered supply of money/credit that otherwise would not be in the system because the well would have dried up, and certainly should have been allowed to dry up in my opinion. Free Market Capitalism is a system with risk and reward. If you take a risk and it pays off, you receive the reward from it. If you take a terrible risk and you lose, you should receive the financial punishment for it. These institutions took incredible irresponsible risks, failed, but yet were still rewarded!

This is not real capitalism, it is a manipulated "get out of jail free" card, and it was done on the backs of the American People. Some of these same Americans took serious risks during this same period, and paid the price for their lack of financial responsibility, yet many of these financial institutions remained unscathed.

But enough about these issues, you want to know why I think stocks are still undervalued, right?

As mentioned above, the dollar has weakened considerably:

If we were to go back in time to the pre 2008 market crash, with the worth of the dollar today after these bail-outs and QE'S, the actual numerical value of the 3 core indices would be as follows;

  • Dow: 8667
  • S&P: 900
  • Nasdaq: 2000

These numbers are roughly a 1/3rd haircut off the current indices, because fiat currency has lost about 1/3rd it's value via dilution, post bail-out, QE 1, and QE 2. If the market indices today were at the above prices, would you be buying the market?

The price of gold essentially tells us the story about the real worth of the dollar today. Taking 1/3rd off the current spot gold price of 1757, leaves us with 1171. Pre market crash 2008, the price of gold was between 700 and 950 dollars an ounce, not far from the 1171 number above.

On October 9, 2007, pre-Quantitative Easing, The Dow closed at 14,164.43, an all-time high, but gold was trading in the 700 dollar range at that time, with higher base interest rates. As of 2/21/12, the Dow closed at 12,965.69, with gold trading in the 1750 dollar range, and a base interest rate of virtually zero. Adding a 1/3rd to the current market indices equates to the following;

  • Dow: 17,286
  • S&P: 1814
  • Nasdaq: 3934

Obviously the numbers above would take into consideration a healthy and vibrant economy with low unemployment along with the QE effect. These numbers would reflect a true bull market, which as anyone can clearly see, we are nowhere near at this time. Therefore, stocks are still far undervalued because the current economic condition does not warrant a bear market which we are currently in now. If we take away all the stimulus, the markets would reflect the numbers I will show again below;

  • Dow: 8667
  • S&P: 900
  • Nasdaq: 2000

Let's look at 5 well known companies and their stocks to see if they are undervalued;

Apple (AAPL) has a forward PE ratio of 10.84,which is more in line with a bearish market than a bullish one.

AAPL PE Ratio Range, Past 5 Years

Minimum 11.35 Dec 2008
Maximum 43.53 Dec 2007
Average 21.53

Google (GOOG) has a forward P.E of 12.27, which is far lower than what internet stocks normally trade for in a bull market.

GOOG PE Ratio Range, Past 5 Years

Minimum 17.55 Sep 2011
Maximum 52.03 Dec 2007
Average 28.70

Microsoft (MSFT) has a forward PE of 10.52, again indicating more of a bear market PE than a bullish one.

MSFT PE Ratio Range, Past 5 Years

Minimum 9.05 Sep 2011
Maximum 20.75 Jun 2007
Average 13.95

Intel (INTC) has a forward PE of 10.37, far too low for this tech giant.

INTC PE Ratio Range, Past 5 Years

Minimum 9.28 Sep 2011
Maximum 47.73 Sep 2009
Average 18.78

Last but not least, Wells Fargo (WFC) has a forward PE of 8.58, which is rather bearish.

WFC PE Ratio Range, Past 5 Years

Minimum 8.93 Sep 2011
Maximum 42.11 Dec 2008
Average 17.30

Notice above the PE ratios were highest in 2007-2008, the height of the bull market run, yet the forward ratios are below average to near the bottom of the 5 year range. Taking this into consideration, compare the 3 major indices now to their bull levels in 2007-2008 right before the economic crash.

Taking into account all the factors above, notwithstanding that overall market trading volume is still on the light side, as there is a lot of money sitting on the sidelines; notwithstanding a PIIGS country disorderly default and/or a world-wide disaster and/or world war, in my opinion the markets should be trading near the following levels:

  • Dow: 14,500
  • S&P: 1600
  • Nasdaq: 3400

I have tried to explain the best I can, how and why the markets are actually undervalued. We must ignore the numbers of the general indices and use adjusted numbers per the several factors I listed above, namely, QE. Bear markets would be indicative of negative GDP, yet we have positive GDP. It is not great GDP, but a lot better than 2008 - 2010. I strongly feel the most important issues we must address are production, artificially low interest rates, and far too much consumer debt. A good deal of our GDP is based on consumer debt, which has to end at some point. We have to get back to what made America great in the first place; true productive exceptionalism.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: This article is intended for informational and entertainment use only and should not be construed as professional investment advice. Always do you own complete due diligence before buying and selling any stock.