How long can stock markets continue to boom?

Share prices around the world are on a tear.

Most developed markets are near five-year highs. The US is now at fresh all-time highs.

Yet, there seems little to justify this good mood. Corporate profits are stagnant by and large, as are underlying economies.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

What's going on? And for how long can it continue?

The truth about share prices and company earnings

The boom in share prices is confusing some analysts. The basic problem, as John Authers notes in the Financial Times, is that since September 2011, "global earnings per share have been flat."

So what rising share prices suggest is that investors are willing to pay more for a given level of earnings. "Price/earnings multiples have gone from 12 to 16 in the process."

In the City jargon, this is known as a re-rating'. It suggests that investors are feeling upbeat about the future, and that they expect earnings growth to improve (because otherwise you wouldn't be willing to pay an apparently high price for today's earnings).

The trouble is, that might make sense if there was any hint that profits would soar in the foreseeable future. However, profit margins are already at record levels. If anything, you'd expect them to drop back closer to their historical average.

So what's driving this enthusiasm for stocks? I'm sure you've already guessed: quantitative easing (QE).

We've mentioned on several occasions in the past that history shows there is no obvious connection between economic growth and the performance of a country's stock market.

Lee Adler of the Wall Street Examiner argues that there also no real connection between profit margins as a whole and share prices. The reason that you often see an apparent correlation is because they are both influenced by monetary policy.

When central bank policy is loose, profit margins are expanding (because people are buying more) and share prices go up too. When the central banks are tightening, people stop buying as much, and earnings go down. Share prices do too.

However, it's not the change in profits that drives share prices. It's the change in the amount of money being pumped into the system. "In the aggregate, price levels are driven by the amount of liquidity in the system. When central banks pump liquidity into the markets day in and day out as the Fed has been doing stock prices rise faster than profits."

In other words, share indexes simply measure how much money is being pumped into the market: profits current or future have very little to do with it all.

How QE forces share prices higher

This is a slightly cynical view of the market's value as a discounting' mechanism of course. But it also makes a lot of sense.

As Brian Reading of Lombard Street Research puts it, QE "works by raising asset prices. It reduces the supply of the assets it buys, generally limited to those with least risk, and increases the demand for the assets it does not buy, with higher risk."

When central banks are buying government debt and other low-risk' assets, they crowd out other buyers (such as pension funds for example). These other buyers have to buy something slightly riskier, such as corporate bonds for example. And so the cost of borrowing falls across the spectrum.

This doesn't do much for the real' economy. Banks are bust, so they are not keen to lend money to small businesses and consumers. But it does do wonders for anyone who can employ a bit of financial engineering.

If a company can borrow extremely cheaply by issuing bonds, then it starts to make sense to buy its own shares back with borrowed money, or to pay special dividends to keep existing shareholders happy.

Indeed, the weak state of the real' economy is also revealed by the fact that companies would prefer to buy their own shares, than borrow money to buy rivals. As the FT points out, in 2006, 60% of corporate loans were made for acquisition activity. Now, it's just 25%, according to S&P Capital IQ, even although interest rates are at similarly low levels.

So on the one hand, QE encourages investors to take more risk: it increases the demand for shares. And on the other, it encourage companies to use debt rather than equity to finance themselves so the supply of shares decreases too.

The Federal Reserve has explicitly said in the past that it wants to drive share prices higher. That's partly to make people feel wealthier, and so more happy to spend. If that seems rather a roundabout way of getting more money into the real' economy, then you'd be right, but the Fed doesn't seem to have many other ideas on that score.

In short, for as long as the printing presses are running, markets can probably go higher. The flipside, as Adler notes, is that "when central banks pull the plug on the money printing, stock prices will come back down, hard, regardless of what profits do."

The Fed isn't going to rein in QE quickly

So, do we have any idea of what would bring an end to QE? On Wednesday this week, we'll hear Federal Reserve chief Ben Bernanke talking to US politicians about his outlook on the economy. Investors have been starting to ponder when the Fed will pull back on QE, and many of Bernanke's colleagues have been making noises about tapering' purchases.

For now though, it seems unlikely that the Fed will pull back. The economy simply isn't strong enough, and there is nothing to stop the Fed as yet inflation remains benign, for now. The longer this goes on for, of course, the bigger the eventual fall.

But the best way for investors to deal with this, as we've noted already, is to buy assets that remain cheap. Our roundtable experts will be looking at their favourite eurozone stocks in the next issue of MoneyWeek magazine, out on Friday. If you're not already a subscriber, subscribe to MoneyWeek magazine.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

Our recommended articles for today

How investors can be fooled by provisions

In the second of his 'cooking the books' series of videos, Tim Bennett takes a look at how companies can manipulate the profit profile they want investors to see - and how you can avoid being fooled.

Two days that totally changed my business

Google has already turned the mobile phone industry upside down. Now it plans to do the same to the traditional computing industry, says Bengt Saelensminde.