What the Dow Jones Industrial Average Reaching a New High Really Means
March 6, 2013 in Economics
I’ll be the first to admit it. I never thought it would happen, the Dow Jones Industrial Average moving to a new record high. But who was I kidding? When trillions of dollars in paper money are created out of thin air and interest rates are simultaneously reduced to zero, where else would investors put their money?
But in the end, we’ll find out that the bigger the rise—a rise in stock prices based not on fundamental improvements to the economy, but on artificial changes to the money supply—the bigger the fall.
Here’s a chart of the Dow Jones Industrial Average:
Chart courtesy of www.StockCharts.com
From the chart, we see a long upward trend in the Dow Jones Industrial Average culminating in new highs reached yesterday. To me, the chart above depicts the end result of increased paper money printing and artificially low interest rates. Sadly, as the headlines have changed, investors have become more optimistic than ever—and this is very dangerous.
What if all we have seen since 2008 is a sucker’s rally in stock prices? After all, corporate earnings growth has turned negative. The U.S. economy is close to contraction. Unemployment in the U.S. remains pathetic. The eurozone situation is deteriorating. Corporate insiders are selling stock at record levels. Bullishness amongst stock advisors sits at multi-year highs. U.S. corporations are buying stock and cutting payrolls to keep profits up because consumers have pulled back on spending.
Under the above scenario, how can the rise in the Dow Jones Industrial Average be real?
By implementing quantitative easing and low interest rates, what the Federal Reserve has essentially done is drive investors to stocks. Just look at 30-year U.S. bonds. They provided investors with a five percent yield prior to the financial crisis; now the yield on the same U.S. bonds is 40% lower at around three percent.
Investors are taking on extra risk just to get back to the returns they once enjoyed. As a result, they are rushing toward the companies in key stock indices like the Dow Jones Industrial Average, not because they are cheap, or undervalued, but because there aren’t many other options for investors out there. Ten-year U.S. Treasuries are yielding negative real returns when you take inflation into account.
I believe the longer the Federal Reserve continues with its quantitative easing and easy monetary policy, the bigger the eventual problem is going to be. Consider this: what happens to the Dow Jones Industrial Average when the Fed stops printing paper money, stops purchasing U.S. bonds, and starts to raise interest rates? The opposite of a rising stock market is what happens.
The Federal Reserve has increased its balance sheet to over $3.0 trillion through quantitative easing and continues to do the same in multiples of $85.0 billion a month. An eventual Fed balance sheet of $4.0 trillion isn’t farfetched.
Dear reader, don’t get lured into the belief that the economy has recovered and the stock market is a safe place to invest again. I’m preaching caution.
Michael’s Personal Notes:
When it comes to looking at the economic growth of a nation, most economists look at indicators such as the unemployment rate, consumer spending, business conditions, and growth in gross domestic product (GDP).
Ironically, as the stock market moves to new highs, all these key indicators of economic growth are painting a scary picture of the U.S. economy.
As I have been harping on about in these pages for far too long now, the unemployment situation in the U.S. economy is a big hurdle to overcome on the way to economic growth. There are millions of Americans still unemployed and looking for jobs—more job seekers than job openings. In real economic growth, you don’t have this scenario.
Similarly, consumer spending, hands down the biggest contributor of economic growth in the U.S. economy, looks to be tumbling. In January, the disposable income of households in the U.S. economy, after taking into consideration inflation and taxes, dropped four percent—the biggest single-month drop in 20 years! If consumers in the U.S. economy don’t have money to spend, then economic growth becomes questionable.
As for business conditions, they appear bright only if you look at the stock market. In reality, they are deteriorating in the U.S. economy. For the first quarter of 2013, the expectations of corporate earnings of companies in the S&P 500 have turned negative. Corporate earnings were negative in the third quarter of 2012, too.
According to FactSet, so far, 105 companies in the S&P 500 have issued guidance for their corporate earnings for the first quarter of 2013. Of these 105 companies, 77% provided a negative outlook. If the percentage of companies with a negative corporate earnings outlook stays at this level, it would be the highest number of companies providing negative outlooks since the first quarter of 2006. (Source: FactSet, February 28, 2013.)
In its initial release, the Bureau of Economic Analysis reported that the fourth-quarter GDP adjusted for inflation in the U.S. economy contracted for the first time in 3.5 years. Its second estimate showed a miniscule increase of 0.1%. (Source: Bureau of Economic Analysis, February 28, 2013.)
With all this said, let me ask you this question: how can we have economic growth in the U.S. economy when economic indicators are showing the opposite?
The sad reality is that there’s no economic growth in the U.S. economy.
What He Said:
“Anyway you look at it; the U.S. housing market is in for a real beating. As I have written before, in the late 1920s, the real estate market crashed first, the stock market second and the economy third. This is the exact sequence of events I believe we are witnessing 80 years later.” Michael Lombardi in Profit Confidential, August 27, 2007. A dire prediction that came true.