Last week, I opined that investing becomes more challenging amid frothy market conditions. Stock prices are on the upswing and most investors are challenged when it comes to selling positions. Rising markets have a tendency to make most investors believe they are smarter than the market and that overconfidence often leads to poor decision making – namely, holding out to sell positions at the top.
The Federal Reserve added another layer of difficulty last week by announcing another round of stimulative monetary policy. As expected, the market cheered and the S&P 500 was off to the races. As of Friday, the S&P stood a level not seen since 2007. But before complacency kicks in for the rest of year, remember that stock prices in the long run respond to earnings growth. For what it's worth, it's likely that stock prices will remain elevated; not only does QE3 provide a price floor but, unfortunately, it also provides the market with a belief that at any sign economic weakness, the Fed will step up.
The third quarter is coming to an end and that means another earnings season is around the corner. And while the major headlines last week were about the new iPhone 5 and QE3, some other worthy information was released. Both FedEx (FDX) and Intel (INTC), two economic bellwether stocks, announced that third-quarter earnings were tracking lower than previously estimated. More so, according to an analyst at Thomson Reuters, 88 companies have already announced that results will come in below previous forecasts. After two-plus years of corporate profit growth, many analysts are starting to believe that growth will become more and more difficult against a generally sluggish global economy.
The fear, of course, is that sluggish or declining growth in the U.S. will keep many companies from hiring new workers. If so, the Fed will have its work cut out for it as Bernanke is now more focused on stimulative efforts to reduce unemployment and not so much inflation anymore. Unfortunately, the Fed doesn't do the hiring, corporations do. Ad because most CEOs are still taking a very cautious approach, any indications that profits are going to be harder to come by is more than enough for them to put a halt to any hiring.
According to an equity analyst at Goldman Sachs, profit margins for S&P 500 companies peaked at nearly 9% last year; margins are expected to decline to 8.7% in 2012. Even so, 8.7% is still a strong number that against this economic backdrop could be subject to further declines. If so, shrinking margins are likely to lead to shrinking earnings multiples. When multiples compress, stock prices drop -- even against bullish earnings news.
Whether the Fed stops with QE3 or QE6 doesn't really matter; those are temporary measures. The more permanent long-term measure is earnings growth. Against a record high stock market, investors should immediately shift their focus from what QE3 means for short-term stock prices and start thinking about what a slowdown in earnings means for prices in the longer.