A Frightening End to QE Is Coming; The Only Question Is When: Opinion
NEW YORK ( TheStreet) -- The macro has dominated the micro in the public markets for more than four years. A return to normal will likely not come without a severe market correction.
In spite of the 14% run-up on the S&P 500 since June 1, capital continues to flow out of the equity markets. It's no wonder why. Since the financial crisis reached its climax in late 2008, companies' fundamentals have become secondary to the activities of central bankers.
As a result, even skilled bottoms-up investors have struggled to generate consistent returns. While rigorous analysis might lead an investor to doubt a particular company's earnings forecast, all bets are off if central bankers continue to pour money into the financial system.
On Sept. 13, Federal Reserve Chairman Ben Bernanke announced a third round of quantitative easing ("QE3"), which comes in the form of an open-ended commitment by the Fed to purchase $40 billion of mortgage debt per month until the job market improves.
In the 24 hours following the announcement, the S&P 500 rallied more than 2.5%, a move that should have been of no surprise to anybody who has taken a basic corporate finance class. The value of an asset is equal to the discounted value of its future cash flows.
If central bankers hold down the discount rate by maintaining near-zero interest rates, a company generating lower-than-expected cash flows might still appreciate in value. Hence the investing environment in which we're operating: Even bad economic news can be interpreted favorably by the equity markets if the news might result in more aggressive Fed action.
At some point, however, interest rates will move up. Dramatically. The Fed will stop printing money to purchase Treasuries (it purchased 61% of the net Treasury issuance in 2011).
Interest rates will again be determined by supply and legitimate demand in the marketplace. International creditors will evaluate the U.S.'s perilous financial position and require substantially higher rates to lend money to the U.S. The "risk-free" rate will again appropriately reflect the risk inherent in lending even to the world's safest economy.
If you remember your corporate finance class, that rapid rise in the discount rate means businesses will suddenly be worth far less than they are in today's distorted public markets. The results could be ugly and they could come sooner than expected.
An upbeat September employment report, in which job creation figures from July and August were revised upwards and the unemployment rate was reported to be at its lowest level in nearly four years at 7.8% pushed the S&P 500 down slightly on Friday.
While the report was not as strong as the headline numbers would suggest, given the jump in the number of self-employed individuals and continued declines in the labor force participation rate, the numbers do indicate that the economy is, at worst, beginning to move more reliably from job destruction to job creation.