The recent announcement by the Federal Reserve that the so-called quantitative easing program will continue unabated has revealed salient facts about tech stocks, as well as the broader economy. Although the focus here is tech stocks, the same analysis can apply to other stocks as well, since the major indices tend to follow the same overarching trends. The Nasdaq index is nowhere near its all-time highs in the low 5,000s, but it may also be nowhere near its real value.
Three Simple Maxims
One could easily describe the current economy as absolutely insane. The Dow Jones Industrial Average is at an all-time high, and other indices are keeping pace with tremendous growth, having exceeded their highs from just before the Great Recession. But other indicators like the workforce participation rate and median household income are much less encouraging. The unemployment rate has dropped steadily, but so has the fraction of the potential workforce that is actually employed. Furthermore, many new jobs are part-time jobs, indicating they are mostly low-paying wage positions. Despite incessant claims of an economy in recovery, the recent Federal Reserve announcement cited “tightening of financial conditions observed in recent months” that, “if sustained, could slow the pace of improvement in the economy and labor market.”
Proceeding on three simple and reasonable maxims, however, the mess can be untangled to some extent.
- You can’t get something from nothing.
- Debt represents the value of future (i.e., yet to be completed) production.
- If you want more of something, subsidize it.
Tech Stocks Jump Following Fed Announcement
The Federal Reserve statement led to a leap in the major stock-market indices; the Nasdaq composite rose roughly 1% on the day relative to its value just before the 2 pm announcement. But what exactly does the continuation of this Fed policy mean?
According to Reuters, the Fed’s “quantitative easing” (QE) policy involves buying “large amounts of assets—in this case, bonds backed by housing mortgages—in an effort to bring down interest rates and boost the economy…To buy bonds, the Fed essentially creates money from nothing, paying for its purchases by crediting the accounts of banks from which it buys the bonds.” And here we can apply Maxim #1: you can’t get money (with any value, anyway) from nowhere. If the value of money is equivalent to nothing, then money will be treated as though it is worth nothing. This is essentially inflation.
But to whom does that money go? (Hint: You probably have yet to receive a check from the Federal Reserve.) Forbes notes that “the major dealers who sell the bonds to the Fed can take that money and buy other bonds in the open market. The new seller then gets paid with that newly created money, which in the bank clearing system, acts just the same as money you and I work for.” So, “The Fed creates $4 billion a day and eventually some of that money goes into equities. And that, of course, helps keep stock prices elevated.” In other words, the Federal Reserve is essentially feeding money into the stock market, artificially raising stock prices.
This effect is clearly visible in the market’s behavior following the Fed announcement. For months, September was billed as the point at which the Fed would begin scaling back its QE program; in response, naturally, markets would view this change as a decrease in free money available, so the anticipation of greater stinginess would reduce prices. When the Fed nixed these expectations, prices jumped to account for what is essentially more free money. This dynamic indicates that tech stocks (among others) currently have prices that are propped up by an organization printing money—something that would be illegal for any private citizen or company to do.
Lower Interest Rates Encourage Debt
Recent college graduates are likely the most keenly aware of Maxim #2: debt is a lien on future (i.e., unfinished) work. It’s easy to create growth now simply by “borrowing” on future labor—which is the hope backing the expansion of government debt and the efforts of the Federal Reserve to keep interest rates low. And that brings us to Maxim #3: by subsidizing debt, current economic policies are encouraging more of it. But that debt must eventually be paid back, meaning a hit to future profits for the sake of current profits.
Eventually, the process must halt—for instance, when the cost of living rises too high relative to the value of labor thanks to Maxim #1 (money isn’t worth anything). Consider the housing market: a growing recognition of an overpriced market led to liquidation as investors (and some homeowners) tried to capture the money before prices fell. The resulting oversupply caused prices to fall, bursting the bubble and sending the economy into a tailspin.
What Are Tech Stocks Worth?
The key for the good investor is identifying the highs and lows: buy low and sell high. Some have pointed out that the average investor—such as the “working stiff” putting money in a 401k—buys high (when the hype is at its peak) and sells low (when fear abounds). So, what’s the story for tech stocks? Of course, each company is a little different, but even in aggregate, making value estimations is pointless—far too many variables come into play. Certainly, recent activity in response to the Federal Reserve means that stocks are overvalued when money isn’t being created from nothing and injected into the stock market.
In light of the three maxims above, the critical takeaway is that money printing and debt don’t create real value or real growth. Eventually payment must be made; otherwise, the soundest economic policy would be to give everyone a printing press and a credit card with no limit, then watch the economy take off. But in that case, consumption is incentivized to the point that production becomes absolutely pointless. Why go to work when you have all the money you need to buy anything you want?
Attempts to limit the negative effects of money printing by only doing it in a controlled manner (if you can call some $1 trillion a year in money printing “controlled”) may avoid a complete economic collapse, but they can still create bubbles as evinced by the Great Recession. But unless one accepts the idea that value can be created simply by printing money (or, more accurately, by changing some numbers on a computer), the effects of such policies must be both temporary and illusory—in that they must be paid for one way or the other.
Assuming the three maxims are true, tech stocks (along with the rest of the stock market) are overpriced. But alternatives for investors are scarce, thanks in part to extremely low interest rates, so stocks have a significant draw. Given that even the Federal Reserve is uncertain about the ostensible economic recovery, the underpinning for real growth in the stock market is probably lacking. Technology companies drive a large part of the economy as dependence on computing power grows, so they may be somewhat insulated from small ups and downs. But given the overall market’s obvious dependence on the Federal Reserve, prices of even tech stocks would likely decline absent the QE program. The question for investors is when that decline will occur. Perhaps the bigger question for the economy at large is how quickly that decline will occur and whether real growth can be sustained to ease the pain.
Image courtesy of bfishadow