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Company Profits And Stock Prices Can Fall Without The Fed Tightening

Most stock investors think that stocks are bound to keep rising, as long as the Fed keeps pumping money into the banking system. But it's not that simple.

Since WWII, most recessions were triggered by Fed tightening, which pushed rates up and slowed the rate of money supply growth. But stock prices can get hammered if the rate of money growth just stays flat for a long time, following a great extended acceleration in money growth.

To apply this idea to the present, we've had a very large increase in MS growth through QE, beginning in 2008 through mid-2011. But since mid 2011, the growth rate in Michael Pollaro's True Money Supply as published in his Forbes column, has been cut in half! The annual growth rate has fallen from 13%+ in '11, to 6%+ today. The decline has happened, despite the continuing QE, due to stricter bank regulations that require more capital.

There is a good explanation as to why these conditions can sooner or later hurt stock prices and the economy. When money supply increases, revenues get bid higher. But costs rise only after a lag, because of accounting rules. So when revenues go up more than historical costs, profits increase temporarily (and unsustainably).

After money supply growth stops accelerating and flat-lines for an extended period, everything changes. Revenue growth stops accelerating and tends to slow down, at first reflecting the fact that money supply growth is no longer rising. Meanwhile, costs keep increasing steadily, reflecting the delayed impact of past rapid money growth on inventories, work in progress, depreciation and amortization. Therefore, profit margins start to narrow and narrow.

After margins fall for a while, businesses demand fewer business products. So revenue growth slows some more, further narrowing margins. Weakening profits then motivate some companies to reduce spending to conserve cash, which depresses revenue growth even more. As this tendency to conserve cash and cut spending continues, for many companies revenues will actually fall despite ongoing increases in the money supply. This--together with the malinvestments funded by the money printing--helps bring on the next recession.

The monetary inflation that caused the unsustainable increase in profit margins also creates another problem. Money printing artificially depresses interest rates, even as it temporarily and artificially elevates profit margins. But after a while, high profit margins make low interest rates want to go higher. Firms can borrow profitably against high profit margins to fund all sorts of activities, including buying back stock.

Rising long term rates reduce the production of durable consumer goods, such as housing; and of capital investment, from cloud infrastructure to oil tanker production. When this happens, of course, the boom rolls over into a recession. Rising rates also eventually knock down PE ratios.

It takes a long time to trace out a top. But topping doesn't require the Fed to tighten, merely to keep doing exactly what they're doing today for perhaps another year or so. The operating profit margins for the S&P 500 have been declining for two years, in tandem with the decline in the growth rate of Pollaro's True Money Supply.

This false boom is guaranteed to end badly, as do all such money printing experiments.

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