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Why the Fed canít raise interest rates part 2

 -- Published: Thursday, 19 March 2015 | Print  | Disqus 

By John Manfreda

In part 1, I wrote about why the Fed canít raise interest rates without the US economy going back into a recession. For part 2, I am going to explain why the Fed canít raise interest rates without crashing the stock market.

The biggest misconception about the stock market is that itís not overvalued. This assumption is based on the average Price to Earnings ratio (PE ratio) of the companies in the S&P500. To justify this assumption, they compare its PE ratios, to the ones in 1999.

Currently, the S&P500 PE ratio is trading at a rate of 19 times earnings. In 1999, the average PE ratio of the S&P500 was trading at a rate of 32 times earnings. The average PE ratio generally trades at a rate of 20-25 times earnings. This fact is why pundits claim that we are not in a stock market bubble, like we were in the year 2000.

What they fail to take into account is todayís modern day interest rate policy. Today the Fed Funds rate is almost at zero, where as in 1999-2000, it was between 5-6 percent.

This artificially low interest rate has enabled companies to borrow money at almost no interest, thus enabling them to repurchase their own stock. Since 2009, companies in the S&P500 have spent over $2 trillion dollars on repurchasing their own stock.

This is why the S&P500 has more than tripled in value since 2009.

This form of borrowing has increased corporate debt by $2.6 trillion dollars. In 2008, corporate debt totaled to the amount of $11 trillion dollars. Now, total corporate debt stands at $13.6 trillion dollars.

If interest rates were to rise, corporations would no longer be able to accumulate debt so easily. And as a result, they would no longer be able to buy back their own shares. Combine this with the fact that revenue is projected to decline in 2015, and corporate cash holdings only amount to $1.98 trillion dollars, companies would have to raise cash in order to pay off their debts.

The only ways they would be able to acquire more cash is by selling company assets or issuing new shares. Considering the fact that almost 95% of corporate earnings since 2009 have been spent on buybacks and dividends; selling off assets is unrealistic. That means the only way to raise money would be to issue new shares.

Part 3 will be about the Bond Market.

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 -- Published: Thursday, 19 March 2015 | E-Mail  | Print  | Source:

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