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Why Constant QE Can't Push Stocks Ever Higher

The Fed will eventually taper only a little and briefly, for the reasons Mr. George Kesarios explains.

But even with endless QE at today's rate of pumping, troubles loom for stocks.

QE has lifted stock prices, because QE causes increases in the supply of "transactions money". The new money bids company revenues higher, well ahead of historical costs. Therefore, average profit margins go up, as we have seen in this money-printing boom.

The other reason for high margins today is huge federal spending. Big spending requires big funding. QE funds federal spending by monetizing more and more federal debt. When the government spends in a big way, it increases consumption spending as a percentage of aggregate output. By this increase, it thereby causes a reduction in productive spending as a percentage of output. This is because the government takes what it spends from private producers. Therefore, with productive spending reduced to accommodate more consumption spending by the government, average business costs eventually become lower. These costs may rise nominally, due to money printing. But they will rise by less than they would in the absence of government spending.

Therefore, lower average costs compared to total revenues equal higher average rates of profit.

Higher rates of profit, due to money printing and government spending, are on nominal profits only. Real rates of profit are actually in decline. But this is a discussion for some other day.

Anyway, this process of widening nominal profit margins makes stock prices jump. But wait! The process that has led to higher nominal profit margins ALSO leads to rising costs that, after a lag, erode bloated margins. Costs inevitably climb, because they also get bid up by the new money. But costs rise only later, after revenues rise, due to accounting principles.

So at a constant rate of money printing, including at rapid constant rates, there is an initial burst of revenue growth ahead of costs. But then costs must rise faster than revenues. With margins getting squeezed from rising costs, businesses slow down their purchases of business goods from other producers. Then caution sets in because of developing profit weakness, so businesses try to shore up cash balances by further cutting spending!

At this point, many business revenues stop rising. Some businesses, especially capital goods makers, see declining revenues. So overall revenues sag, even though the rate of money printing stays steady!

Meanwhile, another silent process helps to end the false Keynesian boom. Artificially elevated profit margins cause depressed interest rates to rise. The wide differential between low rates and high margins makes it profitable to borrow to fund speculations and ventures. So long term interest rates push higher and higher, seeking parity with high profit margins.

No matter how fast the rate of money printing, if the rate is held constant instead of accelerating, the false boom in activity and stock prices is temporary. Once we get past the "sweet spot" in the Keynesian boom, everything changes. Costs and interest rates rise, margins contract, and revenues sag.

As investors gradually notice that earnings and revenues are disappointing, stocks always get hammered. We're in the early stages of worsening conditions. The Fed doesn't need to taper to send stocks tumbling. It merely needs to keep the present rate of QE firmly in place.

This is why momentum stocks such as Amazon and CRM are dangerous. In the future, their revenues will slump and their non-existent profits will suddenly turn into big losses.

After stocks fall and interest rates rise, the Fed will probably adjust. Instead of pumping at the rate of $85 billion per month, it may increase its rate of pumping to some higher and more destructive level. Then fallen stock prices may jump higher again. But as the famous Bill Fleckenstein has explained elsewhere, the key to the bull market in stocks is investor confidence in the Fed's magic. We're getting nearer to the end of such unwarranted confidence.

Disclosure: I am short AMZN, CRM, TOL, MTH, LEN, IBM.