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Preparing for QE2: Three Possible Scenarios to Follow the Fed's Announcement

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Investors have big decisions to make as markets prepare for details of the second round of quantitative easing.

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Editor's Note: The following was posted in real time on our premium Buzz & Banter (click for a free trial).

Next week is going to be big in terms of events and information flow. Let's go through the week:

On Tuesday we have midterm elections. Based on the polls (I use realclearpolitics.com), the House race looks to be easily won by Republicans while the Democrats are likely to keep control of the Senate.

I think this is fully baked into the markets, and even if the Republicans eke out a narrow victory in the Senate, Obama has the veto pen, so I doubt there will be a violent reaction Wednesday morning.

At 2:15 on Wednesday, the real action will start. For the past couple of months, the Fed has been telegraphing that another round of quantitative easing (QE) was coming, and the markets are doing what markets are supposed to do; that is, discount the future event. The problem is that the potential size of the QE2 is both huge and unknown.

This leads to a Goldilocks analysis -- too little, too big, just right. There have been estimates that the market has discounted a QE2 of between $500 billion and $1 trillion. Let's go through the scenarios:

Too Little -- The Fed has almost guaranteed a QE2, so doing nothing seems off the table. $500 billion in my mind has been fully discounted. $500 billion will create a sell-off in commodities and equities. I'm not so sure about Treasuries because that is what the Fed will be buying.

Too Big -- more than $1.5 trillion. Gold (GLD), silver (SLV), oil (USO), and Treasuries (TLT) rocket higher. Equities jump, but it might be a headfake. If the Fed thinks things are that bad, there might be second thoughts on owning equities.

Just Right -- $750 billion to $1 trillion. That's my "just right." I think Treasuries rally, but I'm not sure about gold and equities.

In any case, at 2:14 p.m. next Wednesday, if you have to own anything, Treasuries look the safest. Anything else could see some serious volatility. However, there's one more possibility and it might be the highest probability: The Fed comes out and says it will start buying $100 billion a month, but it hasn't decided how big the program will be. Now, nobody will know what to do, but I doubt the markets will handle that calmly. In terms of pure volatility, that could cause some serious whipsaw action.

Baring any additional information, I suspect I'll be mostly cash into the event, but possibly with a couple of call/put positions. I can't ever remember an event, potentially market moving, telegraphed this far in advance that has so much uncertainty. Think about your positions this week, and what strategy you want to use. Next Wednesday at 2:00 won't be a good time to mull strategy.

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No positions in stocks mentioned.

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