Saturday, August 31, 2013

QE Tapering and the Federal Banks effect on the stock market

Finance is full of buzzwords. Some of them are specific to a certain era, like “junk bond” and “sub-prime”. The latest buzzword being thrown about stock exchanges and brokerage houses is “QE tapering”, “QE” being short for “Quantitative Easing”.

Never heard of it? Well, take a look at the drastic falls made by the S&P 500 and the Dow Jones Industrial Average (DJI) that started on May 31, 2013 – they look pretty much identical, and they are both being blamed on QE tapering.

What is 
Quantitative Easing, and why does it affect stock prices?
Quantitative Easing QE Tapering 
QE is the governmental practice of increasing the amount of money in circulation through the purchase of financial assets. In this case, the U.S. Federal Reserve bank (the Fed) has been buying $85 billion of bonds and mortgage-backed securities every month since December 2012. With $85 billion added to the banking system every month, money is in greater supply so borrowing rates go down.
Companies can borrow more easily, and invest that money in building their business (or paying more dividends / buying back shares). This makes stocks more valuable.

The U.S. is currently in its third round of QE. The first round started in Q4 2008 as a way of addressing the 2008 financial crisis. By the end of Q1 2009, both the S&P 500 and the DJI had started a climb which peaked in mid May of 2013, with the assistance of two more QE rounds. Both indices roughly doubled in value over that time.

But nothing good lasts forever. The Fed cannot simply print money and shove it into the economy because the effect on inflation would be disastrous. That is why the word “tapering” is now being used.

The Fed recently announced that it wants to taper (or slow down) the amount spent on QE and is looking at recent economic data to signal that the U.S. economy no longer needs this level of support.

And so, when surprisingly strong performance was noticed in U.S. housing and consumer sectors last week, both the DJI and the S&P 500 started to topple. Just the suspicion that the Fed would lower its QE spending – certainly before any official announcement has occurred – is causing many investors to start a selling spree. It is predicted that continued good news or an actual policy change from the Fed will initiate a major sell-off.

Fortunately, the artificially high prices that will disappear under QE tapering will not wholly ruin the value of good companies. Companies that have borrowed under low interest rates and which are using the cash to invest in productive assets and exploit opportunities will maintain good value. It is time to look at the Earnings per Share growth of various companies and see if it has resulted from actual earnings, or from measures such as share buybacks and dividend increases.

About the writer:
John Fletcher has served as a consultant in the Corporate Finance departments of Ernst & Young and PricewaterhouseCoopers. He has an MBA in Finance and Marketing from the Schulich School of Business in Toronto, and currently runs his own business consulting firm.