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QE2 and Rising Markets: Where Can Investors Find Real Value?


Don't be seduced by rising securities and commodities prices into thinking that all's well.

Editor's Note: This article was originally published on Charles Cecil's blog on Southwest Fund's website.

As we watch the Fed prepare to pump ever-increasing amounts of liquidity into the US monetary system (between $500 billion and $2 trillion is being discussed), we observe the price of listed securities and commodities rising, giving the appearance that there's a direct connection between Fed QE2 and the actual value of stocks, bonds, and traded commodities. If the Fed were to buy $2 trillion of bonds, the effect on GDP would be an increase of somewhere between 50 and 100 bps according to various economists. How long this increase would be sustained isn't clear, but we've seen that the $1.3 trillion of QE1 had a desirable but not very long-lived effect as revealed by the current economic slowdown. And QE1 took place when the economy was in a crisis, producing a much more dramatic effect than QE2 would now, with the economy in a somewhat stabilized, if lethargic, condition.

As I've argued before, the actual problem with the economy is a lack of consumer demand, not the availability of bank loans, mortgage interest rates, or large amounts of cash held by corporations. Providing more liquidity for the financial system through QE2 won't fix consumer balance sheets or unemployment (if a bank has more capital, it doesn't directly follow that it will hire more people, only that it will be better prepared to write down junky, overvalued assets -- a good thing in itself, but not a major stimulus). So, if QE2 won't result in markedly increased growth in GDP, growth in employment, rebounds in the residential and commercial property markets, consumer goods sales, auto sales, jet sales, boat sales, travel, etc,, why are listed securities and traded commodities rising in price in lockstep with the news of coming QE2?

At my firm, we believe that the increases in securities and traded commodities are predominantly the result of the belief on the part of the investment community that there will be more capital available for acquisition of liquid assets -- which is almost certainly what will be the case. It's simple inflation; inflation that blows a "bubble." Now, this has some good effect, as those who sell securities and trade commodities should make some neat profits, and rising markets will have some positive impact on animal spirits, but this impact won't be sufficient to achieve the desired result of meaningfully stimulating the economy and igniting job creation. Importantly, there's reason to be concerned that when the economy doesn't rebound after QE2, there will be a bad reaction, animal spirits will be dampened, we'll see a collapse of the "bubble" in listed securities and traded commodities that's been created by QE2, and investors will see gains evaporate and lose money (margin calls working the way they do).

Throughout all this QE2 experience, the actual values of the stocks, bonds, and commodities haven't actually changed, and, importantly, the investors who own them have received very little (if any) cash flow from having owned them. The unfortunate reality is that not every investor in listed securities and traded commodities can be the "first one out," so some (many) will experience disappointment as they realize very little in capital appreciation -- or lose capital as the sell-off takes place. This is the illusion, the dark side, of the liquidity provided by listed securities and traded commodities: happily very liquid with markets rising, and painfully liquid when markets fall.

If liquid securities and commodities are a minefield for investors in an unstable economic environment where prices ("value") are being manipulated by government intervention, then where can investors find actual value? We believe that a conservative investment alternative is found in direct ownership of income-producing commercial real estate with no/low leverage as actual value is found in the current cash flow to the investor-owner; cash flow has value because it allows the investor to buy food, shelter, education, medical care, etc. The absence of the use of excessive leverage lowers the asset risk profile, while at the same time allowing for the quarterly distribution of net income to investors. To make the point: We believe that most investors would be very happy to have an annual current stream of income of 5% or greater, combined with asset value and price appreciation over a period of time (five to 10 years).

We recognize that the Fed must take some action to try to stimulate the economy to grow GDP and increase employment; that's the Fed's mandate and the Fed cannot stand idly by as the economy drifts in the wind. However, let's not be seduced by rising securities and commodities prices into thinking that all is well, that our wealth is increasing with the inflating bubble, that asset fundamentals don't really matter in a liquid market -- it was that kind of thinking that contributed to the crisis.

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