The Federal Reserve’s quantitative easing policies — buying government bonds with new money, and increasing the asset levels of the Fed’s balance sheet in the process — is a bad policy.
When someone sells a government bond, the Fed credits the seller with a payment to his account. So while money is not literally printed, the monetary base does expand. As the Fed has purchased more and more bonds, the price of bonds goes up while yields go down. Interest rates also move inversely to bond prices, so interest rates also go down. The goal here is to make it easier for people and companies to borrow money, and to use that money to stimulate the economy by purchasing goods and services.
But this scheme creates several problems.
As bond yields have now contracted to the point where they barely yield anything, people look for interest income in other securities. They move into dividend-paying stocks. They also move into equities in general to hunt for capital gains to replace the lost yields. The result is an artificial rise in the prices of stocks — increases in stock prices not due to earnings growth or the execution of the companies in question, but simply because money is fleeing other assets.
Yet earnings were not so hot in Q3. Zacks reported Q3 was the weakest since 2009, with total earnings down 2.2% and revenues down 3.8% year-over-year. Exclude finance from these results and earnings went down 6.9% on a 4.9% decrease in revenue. We got disappointing results from the former Untouchables: Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG), Amazon (NASDAQ:AMZN) and Intel (NASDAQ:INTC). Q4 estimates are coming down as a result. With real disposable income falling and wages stagnant, this shouldn’t be a surprise.
Thus, the stock market is being buoyed not by earnings power, but by QE.
How Long Can The Bubble Inflate?
At some point, the Fed is going to have to stop printing money, probably when inflation becomes a threat. As we all learned in sixth grade, when there is too much money chasing too few goods, we get inflation. If inflation gets out of control, the Fed will stop QE, and if the economy has not improved such that company earnings are growing organically (not tinkered with via buybacks and cutting expenses), then there won’t be anything holding up the market — look out below.
Some say inflation is already out of hand. Trouble is, the government keeps changing how inflation is calculated. The official CPI is around 2%. Yet if we measure inflation like we did in 1990, it’s closer to 5.5%. If we use 1980 standards, it’s closer to 10%. Yes, 10%.
People living on fixed incomes, who have been forced to move assets into stocks from bonds as yields dry up, are most at risk in this scenario. We’re talking about older folks and retirees. Any such reader who has increased exposure to stocks to chase income and capital appreciation — be very careful about which stocks your money is in, and set stop losses.
How will you know it’s time to get out of stocks, that the Fed is about to pop the QE bubble? If the reported CPI jumps several months in a row, that’s a big warning sign. Another key is bank lending. As we all know, banks aren’t lending much right now. Businesses are having trouble getting loans. People are having a hard time getting mortgages. Once lending picks up, the velocity of monetary expansion increases — as the Fed prints money, banks lend it right back out again. That will drive inflation.
OK, So Now What?
How can you play this scenario? First, as always, have a diversified long-term portfolio. If you have exited bonds, try to redeploy that money into hard assets. The best vehicles for these hard assets are private investments. As a broker for private equity, I’m fortunate to have access to these. Opportunities do exist for laypeople, but you have to pound the pavement for them.
Otherwise, look to real estate stocks and REITs. Public Storage (NYSE:PSA), Getty Realty (NYSE: GTY), and BRE Properties (NYSE:BRE) are a few suggestions. The Third Avenue Real Estate Value Fund (MUTF:TAREX) has always been a conservatively managed mutual fund able to scoop up distressed assets on occasion.
It’s always good to have some gold in your portfolio. The SPDR Gold (NYSE:GLD) is a good choice.
Business development companies offer huge yields, and they invest in some of these private opportunities I mentioned. Prospect Park (NASDAQ:PSEC), Blackrock Kelso (NASDAQ:BKCC), TICC Capital (NASDAQ:TICC), Apollo Investment (NASDAQ:AINV) and Main Street Capital (NASDAQ:MAIN) are some ideas.
Finally, value stocks in general are the next best asset sector to hold in this scenario. The theory is that these stocks are undervalued as it is, so the market hasn’t bid them up artificially past their intrinsic worth. My favorite value play at the moment is EZCorp (NASDAQ:EZPW), a pawnshop operator that is seeing huge growth in alternative consumer finance products. It’s selling for half of its intrinsic value, with a P/E of 7.
You should also look at any number of value ETFs. I like small-caps, so the Vanguard Small Cap Value ETF (NYSE:VBR) is a great choice.
I’ll conclude with Ludwig von Mises’ caution about credit expansion. “What is needed for a sound expansion of production is additional capital goods, not money or fiduciary media. The credit boom is built on the sands of banknotes and deposits. It must collapse.”
As of this writing, Lawrence Meyers was long EZPW. He is president of PDL Capital, Inc., which brokers secure high-yield investments to the general public and private equity. You can read his stock market commentary at SeekingAlpha.com. He also has written two books and blogs about public policy, journalistic integrity, popular culture and world affairs.