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What Happens When QE2 Ends?


What the end of bond-buying means for Mr Market.

Tomorrow, on March 9, the S&P 500 is scheduled to celebrate its second bull-market birthday. The historic rally has been dramatic and, for many strategists and analysts, unexpected. Two years ago, how many of your friends and neighbors would have bet that the US stock market would rocket up more than 90% after suffering a nearly 60% drubbing over a 17-month period?

Investors have taken notice: there has been a clear upsurge in the amount of cash now making its way into stock mutual funds. Over the four weeks ending February 23, some $16.5 billion flowed into stock-market mutual funds, far outpacing the $6 billion that went into bonds funds, according to the Investment Company Institute.

It's not just retail investors that feel more optimistic about the equity market, either. Their financial advisers are similarly much more upbeat. Charles Schwab recently released its ninth semi-annual survey of independent registered investment advisers (RIAs), which revealed a sharp increase in advisers' optimism since July 2010.

More than three-quarters (77%) of advisers surveyed now expect the S&P 500 to rise in the next six months, up from 63% in the previous survey. More than half of advisers (56%) are bullish when it comes to stock market performance over the next six months, while only 10% see themselves as bears.

The lack of hand-wringing is also evident in the Chicago Board Options Exchange's Volatility Index (VIX), otherwise known as the "fear gauge" as it tracks expected volatility in the stock market. The index is now just over 19 versus 53 in March 2009, meaning Mr Market appears a lot mellower these days.

Still, other market participants feel less confident about whether this stock market rally can keep running to the upper right hand corner of the chart. Yes, corporate profits have enjoyed a remarkable rebound. Economic data has also been generally better-than-expected, with recent good news including upside surprises in US and global manufacturing and service data, auto sales, same-store sales, initial unemployment claims and private payroll data.

However, a question some skeptics pose with increasing frequency is this: what happens in the investment markets if the Federal Reserve does not implement another round of radical monetary experimentation?

Specifically, Federal Reserve Chairman Ben Bernanke and his allies on the FOMC reacted to the economic downturn by lowering short-term interest rates to near zero and also launching controversial bond-buying programs -- known as QE1 and QE2 -- to stimulate the economy and defend against the threat of deflation, or a persistent drop in consumer prices.

Bernanke has remained very clear that he intended, with these extraordinary monetary actions, to drive investors back into risk assets such as stocks. He wrote about the issue in the Washington Post last November and even recently mentioned the rally in the Russell 2000 during an interview on CNBC. If investors see the value of their stock portfolios rise, so the thinking goes, then they will feel more confident and spend a little extra at the local mall. Business owners, pleased with a pickup in demand, will start hiring again.

The stock market has certainly reacted to QE2 very favorably: since late August, when Bernanke first opened the door to another round of bond buying, the SPDR S&P 500 ETF (SPY), which includes holdings like ExxonMobil (XOM), Apple (AAPL), Microsoft (MSFT), IBM (IBM), and Bank of America (BAC) is up 23%. However, as the Treasury securities purchasing program draws to a close in June, some strategists worry about what happens next. The question becomes whether this rally fizzles once robbed of its aggressive public sector support.

Certainly, some of the most skilled professionals are concerned. Even as retail investors and their financial advisers feel more confident about equities, the so-called "smart money" has become much more pessimistic. For instance, the most recent TrimTabs survey of hedge fund managers showed that these well-heeled traders have now turned bearish on US equities, with most managers attributing the stock market rally to QE2. Many think this rally will end when the quantitative easing stops in mid-year.

Specifically, about 40% of the 89 hedge fund managers surveyed are bearish on the S&P 500, up sharply from 26% in January, while only 26% are bullish, down from 37%. Bullish sentiment less bearish sentiment is negative for the first time since November.

Their worries would seem defensible. Investors might traditionally think of four drivers to the market: fundamentals, fund flows, technicals and valuation. But, investment strategists say, there is now a new one: the Fed's balance sheet.

According to TrimTabs, the level of the S&P 500 and the size of the Fed's balance sheet have exhibited a positive correlation of 88.4% since the start of QE1 in March 2009. Meaning, ever since our policymakers employed these non-traditional monetary maneuvers two years ago, the "500" has generally tended to rise as a flood of money hits the market.

So, what happens when these monetary efforts stop? David Rosenberg, the chief strategist at Gluskin Sheff, a Toronto-based wealth management firm, says that we already know what will happen if QE2 does indeed end in June, as scheduled, and there is no QE3. When the Fed stops quantitative easing, he says, risk appetite fades and the economy sputters.

Last year, from April 23 through to August 27, the Fed allowed its balance sheet to shrink from $1.207 trillion to $1.057 trillion for a 12% contraction as QE1 drew to a close. During that time period, Rosenberg details, here is how the capital markets responded: S&P 500 sagged from 1,217 to 1,064; CRB futures dropped from 279 to 267; fear intensified as the VIX index jumped from 16.6 to 24.5; the dollar firmed; gold rose from $1,140 to $1,235; and investors flocked to the safety of government debt, with the yield on the benchmark US Treasury note plunging from 3.84% to 2.66%.

Vinny Catalano, president and global investment strategist with Blue Marble Research, says that as the second-quarter of this year progresses, investors and traders will likely start focusing on the end of QE2 and whether the US economy has achieved its escape velocity, meaning growth without the steroids of government stimuli.
"Bernanke believes that the economy is on the path toward a sustainable economic expansion," says Catalano. "Let's hope that he's right because, if he's wrong, I frankly don't know what other tricks are left in the bag for the Fed and the Treasury. I would anticipate that investors, going into the second quarter, will start looking past the end of QE2 and what that really means for the economy and the markets."
Still, other strategists, while conceding that worry about the end of QE2 is warranted to some extent, argue that the Fed has other tools at its disposal that could allay investor concerns.

Doug Roberts, chief investment strategist at Channel Capital Research, says that central bankers, for one, could reassure market participants that they're willing to transition from QE2 to QE3 should economic conditions justify more quantitative easing. (In fact, just this week, Atlanta Fed President Dennis Lockhart reportedly said that, should oil prices keep climbing, the Fed might be forced to make a new round of asset purchases).

Also, Roberts says, while QE2 might be concluding, it's also just as clear that the Fed will likely keep short-term interest rates parked near zero for an "extended period." In other words, investors can expect these policymakers to remain generally supportive of easy money policies.

"We are in a secular bear market interrupted by cyclical bulls," says Roberts, "and, if you look at the history of secular bear markets, you'll see that as long as government continues to spend then we'll have these nice rallies," adding that he remains overweight small-caps (IJS) and Technology (XLK) at this time.

Also see Lloyd's Wall of Worry, including a countdown clock to the end of QE2.
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