What Will Happen When the Fed Ends the ‘Steroid Era’?

This has been a banner year for U.S. companies and, in turn, stock-market investors. The Dow Jones Industrial Average and S&P 500 have risen to one all-time high after another, thanks to record earnings.

But if you were to ask a sampling of professional and amateur investors what they think is the biggest reason for those outsized gains, I’ll bet most of them would give you the same answer: The Federal Reserve.

Since the depths of the global financial crisis in 2008, the Fed has kept interest rates at historically low levels and pumped trillions of dollars of liquidity into the markets. It’s obvious that this accommodative monetary policy has artificially pumped up asset prices and inflated corporations’ profits.

But is there a way to quantify just how much companies have been helped by Chairman Ben Bernanke’s policies? And what will happen when the Fed inevitably raises interest rates and eases its purchase of government bonds?

How much has Ben Bernanke helped inflate corporate profits?

Juiced-Up Earnings

Sometimes it can be easy to forget just how large a role interest rates play in both personal and corporate finance.

Consider the numbers: In 2007, interest paid by U.S. businesses peaked at $2.83 trillion. But as the central bank kept slashing its benchmark federal funds rate, interest costs fell sharply, to just $1.34 trillion in 2011.

In 2009, when the stock market was bottoming and businesses were still trying to dig out of the hole created by the financial crisis, quarterly earnings for S&P 500 companies were less than $20 per share on average, and they were paying about $4 per share in interest. Now their interest expense is just $1.50 per share, and they’re generating an average of $26.70 in earnings per share.

In other words, corporate America has enjoyed a substantial decline in its cost of capital, which has greatly padded its bottom line. If we quantify those changes, the number produced by the equation is astonishing:

Since 2009, about 34 percent of the S&P 500’s earnings growth is directly attributable to savings from the reduction in interest costs on company debt.

When the Drugs Wear Off

The U.S. economy is recovering, but growth is wobbly. So the Federal Reserve is likely to maintain its program of bond and mortgage-backed securities purchases at the current level of $85 billion per month at least for the time being.

However, at some point in the next few months, the Fed will start to taper its bond buying. When it does, the bull market in stocks may stagger or come to an end. And interest rates will surely begin to climb again.

But big corporations got big in the first place by having the foresight to anticipate major changes in the economy. So they’ve already planned for higher borrowing costs. They’ve used the past couple years to shift their debt loads further into the future. Back in December 2011, the heaviest volume of corporate loans was set to mature in 2014, 2016 and 2017, according to Morgan Stanley. As of this June, most loans now mature in 2017, 2018 and 2019.

And, yes, they’ve also got the Fed working on their side. The central bank is not only using its primary tools — monetary injections and ultra-low interest rates — to protect the wealth of Wall Street. It’s also closely monitoring the markets, and using clandestine means to make sure that 5 percent pullbacks don’t turn into 10 percent corrections, or even 20 percent bear markets.

So what will happen when the Federal Reserve ends its quantitative-easing program, likely at some point next year? Will Bernanke’s successor implement a new backdoor stimulus under a different name? Will corporate America be able to count on some form of permanent QE? And, if not, will companies — and investors — be able to make much money?

Only time will tell. To see how I’m positioning part of my portfolio, click on this link to go to Money and Markets’ Facebook page.

Best wishes,

Douglas