For months and months, many of us have been discussing and evaluating the costs and benefits of the Federal Reserve’s stimulus — the third round of the Fed's quantitative easing, or QE3 — through which it is buying $85 billion each month in bonds to stimulate economic growth.
Twelve months into QE3, the Fed is facing a difficult choice: Does it remove stimulus and risk stifling the economy, or does it continue pumping cash into the economy and risk sparking inflation?
Perhaps a better question would be: Is the stimulus working at all? An analysis of consumer spending may be able to shed some light on this issue.
The reason consumer spending is important in this context is that consumer spending accounts for 70 percent of total U.S. economic growth. It is, by far, the most important component of GDP. To better understand why consumer spending is so important, we should review why the Fed is using QE3 — its bond-purchasing program — to stimulate the economy. The Fed hopes that by buying bonds with long maturities, it can hold long-term interest rates on treasuries, mortgages and other fixed-income securities, at artificially low levels.
The expectation is that, if rates are low, individuals and companies will be able to afford to borrow at a lower cost, and therefore will borrow more. It follows that once the money has been borrowed, the individuals and companies that borrowed it will spend it, stimulating economic growth.
As mentioned above, this is the third round of quantitative easing, and started 12 months ago. Each month, the Fed has been buying $85 billion in bonds. Over the 12-month period, it has spent just over $1 trillion. Our national debt is about $16.75 trillion, so this $1 trillion represents about 6 percent of our total national debt (so far).
The national debt, by the way, amounts to about $53,000 for every man, woman and child in the United States. The Fed’s QE3 program represents about $3,200 of that amount (so far).
Is It Working?
To try to judge the effectiveness of the Fed’s QE3 program, we need to look at consumer spending: Are people spending money in the economy?
The nearby table below shows the quarterly consumer spending totals (in billions of dollars) along with the quarter growth figures and the corresponding change in the Standard & Poor's 500 and the growth of the index during each quarter.
From the bottom of the recession, when consumer spending bottomed just below $10 billion in the second quarter of 2009, the S&P 500 ended that quarter at 919.32 — after setting a low of 666 during the quarter. (Scroll down the page for more on the significance of the S&P 500’s performance during this time period.)
From this low for consumer spending, the economy has seen spending grow, from the second quarter of 2009 through the second quarter of 2013, by a total of about 9 percent over the 17 quarters represented.
On average, consumer spending has grown by about 0.5 percent each quarter. In the three quarters since QE3 began, consumer spending has grown by slightly less that 0.5 percent each quarter. Anemic at best.
I have provided a comparison to the S&P 500 because I want to show how the Fed’s bond-buying program has resulted in a huge jump in stock prices, without the intended increase in consumer spending. During the same time that consumer spending has risen by about 9 percent, from the second quarter of 2009 through the second quarter of 2013, the S&P 500 has gained 75 percent.
If we think through this logically, stocks are ownership shares in companies. Companies make money by selling goods and services. Someone has to buy those goods and services for companies to grow their revenues and earnings. In a recovering economy, one would expect to see a reasonable correlation between consumer spending, which again represents 70 percent of the total economy, or roughly 70 percent of the money that companies generate in revenues and stock market performance. In other words, if stocks are increasing rapidly, there should be a strong growth rate in consumer spending to justify the increasing value of stocks.
When we measure the valuation of the stock market, or an individual stock, we look at various metrics, such as price to revenue per share or price to earnings, to get a sense of whether the market or a stock is fairly valued, overpriced or undervalued. When we look at the current stock market, we find that stocks are trading at about 20 times trailing earnings. This is a relatively high valuation, especially given the future prospects for economic growth — the economy is not expected to grow at a robust rate in the foreseeable future.
Because consumer spending has not increased significantly from the bottom of the economic cycle, despite the $1 trillion-plus that the Fed has pumped into the economy, we have not seen growth in corporate revenues and earnings at a level significant enough to justify the current level of the stock market.
While the Fed is clearly trying to stimulate the economy, the result of its actions has not been significant growth in consumer spending, which is what the Fed wanted, but instead has been a rapid rise in stocks. Rather than recognizing that QE is not working and ending it, the Fed has chosen to ignore the obvious and continue buying bonds each month.
The longer it continues pumping cash into the bond market, the more severe the reaction will be once it decides to end QE3. Although the intention is to slowly remove this stimulus (taper the bond purchases over a period of months), I believe it is wishful thinking to believe that the stock market will not react violently to any reduction in the stimulus activities of the Fed.
In essence, the Fed has created a bubble in stocks; a bubble that must burst to bring stocks down to appropriate valuations based not on the euphoria surrounding Fed stimulus, but actual revenues and earnings.
Once the Fed removes the stimulus from the economy, rates, which are artificially low, will jump up to where they should be (much higher than where they are today), and stocks will correct down to more reasonable valuations. Only after these adjustments have taken place in the financial markets will there be investment opportunities with acceptable risk parameters.