The Simple Trick That Skewed the S&Ps P/E Ratio For Everyone

Investing is about value, buying low and selling high. But how do you determine value if the most popular value gauge has been compromised. Yes, via a 2008 economic stabilization act, Congress changed the ‘E’ of P/E.

In 2008 everyone (aside from short-sellers) were in crisis mode. Banks, Federal Reserve, Treasury Secretary and the President were ready to do whatever it takes to get the job done.

The job? Bail out banks and push the S&P 500 higher (SNP: ^GSPC). How? Didn’t matter.

The job got done, and with stocks as with sausages, if the end result tastes good you don’t ask how they’re made.

Not a day goes by where we don’t read about bank profits, bank bonuses, and bank shenanigans to make more profit. So let’s talk about bank profits for a moment.

Not everything that shines is gold and not everything that’s black on the income statement is profit.

From Mark-to-Market to Mark-to-Make-Believe

There was a time when banks loved the Mark-to-Market accounting model, because it allowed them to showcase truly miraculous real time profits. By 2006/07 the financial sector accounted for over 40% of S&P 500 earnings.

Things changed in 2007/08. Mark-to market wasn’t so popular with banks because it revealed enormous real time losses. Bankers don’t like to see red. Bankers prefer to hide their losses.

The Federal Reserve and Congress decided that’s a good idea since losses erode confidence.

Bankers lobbied the Financial Accounting Standards Board (FASB) to change the fair market accounting rule – rule 157 – but the FASB resisted. The FASB knew that changing fair market or Mark-to-Market was a free pass that practically required no write-downs ever.

However, via the Emergency Economy Stabilization Act of 2008, Congress gave the SEC the authority to suspend Mark-to Market accounting. FASB was strong-armed and FASB rule 157 was suspended on April 2, 2009.

FASB 157 – What Does it Mean?

Since April 2, 2009, banks are basically free to value their toxic assets as they please. This example illustrates how the financial engineering formula works in real life.

The two charts below show 1) S&P 500 P/E ratio and EPS (based on as reported data) 2) S&P 500 financial sector EPS (datasource: Standard & Poor’s).

Bank ABC holds mortgage-backed assets originally valued at $1,000. After running some proprietary and non-verifiable models the bank determines it will eventually sell the asset for $950. The loss, termed credit loss, is only $50.

However, because of MBS bad rep, the banks portfolio is currently worth only $500. The actual current value ($500) minus the credit loss ($50) is called noncredit loss ($450).

The $450 noncredit loss is recorded on the balance sheet under “comprehensive income,” but is not run through the income statement. Those losses don’t affect earnings, and are excluded from banks’ regulatory capital calculation.

That’s right, every single bank earnings report since April 2, 2009 did not account for losses from toxic assets.

This means that the P/E ratio for ETFs like the Financial Select Sector SPDR (NYSEArca: XLF) and by extension the SPDR S&P 500 ETF (NYSEArca: SPY) is skewed.

It’s been nearly four years since the FASB rule 157 change, so why write about it now?

Because the European Commission is proposing a similar accounting change, and (this is a real shocker) confiscation of private assets to help banks. More details here: Europe Proposes Mass Confiscation of Private Assets

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

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Fed Needs Help of its Worst Enemy to Unload QE Assets

Talk about a classic catch 22. The Federal Reserve has been buying Treasuries to depress interest rates and spark the economy. With a bloated balance sheet, the Fed needs the help of its arch enemy to unload assets.

1,273%. That’s how much the Federal Reserve’s balance sheet has mushroomed since 1990.

As of January 22, the Federal Reserve owns $2.228 trillion worth of U.S. Treasuries and $1.532 trillion worth of mortgage-backed securities.

Various other holdings bring the Fed’s balance sheet to $3.815 trillion.

The chart below provides a visual of the sharp balance sheet increase since 2008.

Buying those assets is the easy part, but how will the Fed unload them?

The Fed’s Enemy – Who?

The Federal Reserve engaged in massive quantitative easing (QE) to depress interest rates. Low interest rates forced investors into stocks and defrosted the frozen credit markets.

By extension, QE drove up stock indexes like the S&P 500 and Dow Jones (NYSEArca: DIA). Bernanke termed this the ‘wealth effect,’ which the Fed hoped would spill over into the economy.

The Fed’s biggest enemy is interest rates, rising interest rates to be exact. Particularly important is the 10-year T-note yield.

Rising interest rates make Treasuries and Treasury Bond ETFs like the iShares 20+ Year Treasury ETF (NYSEArca: TLT) more attractive than stocks.

Rising interest rates also result in higher loan and mortgage rates, which are speed bumps for the economy and real estate.

The chart below, published on December 12, plots the S&P 500 against the Fed’s balance sheet and 10-year Treasury Yields. Yields are inverted and the chart shows that the Fed has lost control over yields.

How The Fed’s Arch Enemy Can Help

The Federal Reserve is the biggest buyer and owner of Treasuries. The Fed can print money and buy securities all day long.

But, who will end up buying all the Treasuries the Federal Reserve has amassed? What happens when the Fed becomes the seller? The Fed can’t print buyers. There has to be a demand or the Fed (if possible) has to create a demand.

Irony at its Best

What makes Treasuries attractive? High yields, which ironically is exactly what the Fed is trying to avoid. High yields are bad for stocks and bad for the economy, but may be the Fed’s only hope to eventually unload assets.

There’s another caveat. High yields translate into lower prices. As yields rise, the Fed’s Treasury holdings – and Treasury ETFs like the iShares 7-10 Year Treasury ETF (NYSEArca: IEF) – will shrink.

Are there other alternatives? How about doing nothing and let the free market do its thing. Perhaps that’s what Bernanke and his inkjets should have done all along.

There is another problem largely unrelated to QE and the Federal Reserve. It’s ownership of U.S. assets (not just Treasuries).

We know that the Federal Reserve owns much of the Treasury float, but more and more U.S. assets are falling into the hands of foreigners. More and more U.S. citizens have to ‘pay rent’ to overseas landlords.

Here’s a detailed look at this economically dangerous development:

US Assets are Falling into the Hands of Foreign Owners at a Record Pace

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (stocks, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

Operation Twist about to Expire – Will it be Replaced by Outright QE?

The Federal Reserve’s $45 billion a month Operation Twist program is scheduled to expire at the end of this month. Based on the sound bites of several Reserve presidents, there will be a replacement. Will it be more outright QE?

Operation Twist is circling the drain, set to expire on December 31, 2012.

Will Operation Twist be extended or even be replaced by outright QE?

What’s the difference between Operation Twist and Quantitative Easing (QE)?

Operation Twist Basics

Since September 2011, the Federal Reserve has been buying about $45 billion of longer-term Treasuries per month with the proceeds from sales of a like amount of shorter-term debt.

Unlike outright QE purchases, the Operation Twist asset reshuffle does not add to the Fed’s balance sheet.

Will Operation Twist be Replaced by Outright QE?

Boston Federal Reserve Bank president Eric Rosengren, one of the most vocal proponents of Fed asset purchases, advocates to continue spending $45 billion a month buying long-term Treasuries.

St. Lois Federal Reserve Bank president James Bullard has a different opinion. He said that the expiring Operation Twist program should not be replaced on a dollar-for-dollar bases, because asset purchases that expand the balance sheet (like QE) have a bigger effect than Twist.

QE Tally

So far the Federal Reserve has purchased about $2.4 trillion worth of government bonds and mortgage-backed securities.

During QE1, the Fed spent about $78 billion a month.

During QE2, the Fed spent about $75 billion a month.

During QE3, the Fed is spending about $40 billion a month.

Concurrent to QE2 and QE3 the Fed is reinvesting the proceeds of maturing securities. Based on a balance sheet of $2.4 trillion, this is a significant amount.
Abount $25 billion a month.

For the month of December, the Fed will spend about $65 billion buying Treasuries and mortgage-backed securities. This is “new” money.

An additional $45 billion of the proceeds from selling short-term Treasuries is re-invested in long-term Treasuries.

QE’s Effect on Treasury Prices

What does all of this artificial demand for long-term Treasuries mean for Treasury prices and corresponding ETFs like the iShares Barclays 20+ year Treasury Bond ETF (TLT)? It appears that the effect of QE3 on Treasury prices has been muted. It certainly hasn’t driven prices up as should be expected.

In fact, 30-year Treasury prices have been stuck in a trading range capped by two long-term resistance lines and buoyed by an 18-month support line. As long as prices remain in that range the stalemate is likely to continue.

With strong seasonality for stocks straight ahead (and an inverse correlation between stocks and long-term Treasuries), I assume that price will break down.

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.