The Fed’s Potemkin rally: Rosenberg

Potemkin is the name of a phony village created in the late 18th century by a Russian minister named Grigory Potemkin, who was celebrated for leading the Crimean military campaign. He constructed a shell of a village that appeared exotic from the outside, but was totally fake and he staged fireworks from inside the wall of this ghost town to impress Empress Catherine II when she visited Crimea in 1787 — or so legend would have it.

A modern Potemkin could be this: A stock market that is up around 14% over the past year when corporate earnings are only up 4%.

It’s become quite fashionable to explain the sustained equity market rally in the context of what corporate earnings have done this cycle. Profits have climbed 150% from their lows (on a fourquarter trailing basis) and the S&P 500 has risen 130% from its lows, leaving valuations, so we’re told, at attractive levels. The conclusion is that this is an earnings-driven cycle, and the U.S. Federal Reserve has nothing to do with it.

Meanwhile, our work shows the Fed has had much to do with it. While there has been no escape velocity within the real economy, that 87% correlation with the central bank balance sheet (not to mention negative real short-term interest rates) has been responsible for up to 500 rally points in the S&P 500 this cycle.

We estimate that had the Fed not intervened the way it did in early 2009, the S&P 500 would have dropped closer to 475 than the 666 it did sink to.

Histor y can never be changed, but is constantly open to interpretation.

Corporate profits have soared, but how they were driven, the quality of those earnings and the sustainability of the growth is open for debate.

Here is the prime example. On a four-quarter trailing basis, S&P 500 operating EPS currently tops US$100, while back near the mid-2007 market peak it was closer to US$90.

But back in the spring-summer of 2007, interest expense per share was US$52.54 compared with a mere US$19.47 today. One reason could well be that corporations have pared some of their debt to shore up their balance sheets.

According to S&P data, the long-term debt per share is about US$480 while in 2007 it was US$640 — so, indeed, lower per-share debt may account for about a quarter of the reduction in interest expense per share. The tax take in 2007 was equivalent to US$43.72 per share, while after all the fiscal support

Fed intervention prevented a much

bigger drop

from the Treasury this cycle, it’s now US$37.11.

Combined, these two factors have added some US$30 per share to corporate earnings benchmarked from the peak of the previous cycle. That would suggest operating EPS north of US$75 right now, instead of US$100-plus, if the Fed and federal government had simply let nature take its course.

This is not to dismiss the earnings bounce out of hand. An 87.5% increase in a mere four years (we bottomed at US$40 back in 2009) is nothing to sneer at. It only puts the valuations on the market into a certain perspective.

Interpretation and analysis are always important and far more useful than doing simple arithmetic on what the market does in terms of achieving a new high. Leave that simplistic approach to Wall Street strategists.

If we go back to what was, in fact, sustainable earnings growth during the dot-com phase, you would have come up with different valuation metrics than what the consensus was comfortable with at the time. Ditto for the financial engineering that drove profit growth in the 2002-07 cycle.

This time around, the bubble is neither in technology nor housing, but in the Fed’s balance sheet and, more broadly speaking, its consequences on this cycle’s risk appetite.

Moreover, with the Dow at a new high there is a lot of reporting about where we are now compared to where we were near the prior highs in the summer of 2007. But what matters most are earnings and the multiple. Everything else is noise.

Back in mid-2007, the reported EPS was US$87 (reported earnings are the actual non-scrubbed numbers — i.e., they include writeoffs and other so-called non-recurring items that operating earnings omit). As of the last quarter, it was US$89. So we are back to peak earnings.

Back in mid-2007, the reported P/E ratio was 17.7x on trailing. Today, that P/E multiple sits at 17.3x. So we are back close to peak multiples.

Granted, the Fed has acted, which means the lower interest payments and lower taxes are real. But even though the Fed is unlikely to raise rates, it will not be possible to engineer a further decline in interest expense either. And corporate tax rates are also unlikely to fall.

Therefore, the legitimate questions are: How strong can EPS growth be from here if it is limited to organic earnings growth? And does this ultralow interest rate environment warrant further multiple expansion or a historically wide equity risk premium?

The bulls managed to call this cycle right, but there is some doubt whether we will achieve multiple expansion and earnings expansion beyond what we experienced near the 2007 peaks.

This is why we are focused on holding companies where the free-cash-flow yield is significant. We don’t need multiple expansions or earnings expansion, because stable healthy cash flows are still available if you know where to look for them.