QE2 And Midterm Election Positions

November 01, 2010

Some thoughts on investment questions preceding one of the most news-filled weeks of the year ...


In advance of the most news-filled week of the year—between the mid-term elections on Tuesday and the Fed’s monetary easing announcement on Wednesday—we offer our thoughts on the following investment questions:

Stocks have been up for eight consecutive weeks, and the S&P 500 has gained 13%. What has been driving the rally in the stock market?

Since Fed Chairman Bernanke unexpectedly announced plans for another round of quantitative easing (i.e. asset purchases funded with newly printed money) in late August, the stock market has been in a virtually uninterrupted advance. The anticipation of this monetary stimulus, rather than substantive improvement in the economic backdrop, has been the predominant factor driving the recent stock market rally. How do we know this? Because commodity prices, foreign currencies, and inflation expectations have ramped upward over the past two months in approximate proportion to the gains in stocks. In other words, U.S. stocks have made negligible upside progress relative to commodities and foreign currencies.

Is the stock market poised to “sell the fact” of the Fed announcement, after having “bought the rumor” over the past two months?

Although a number of Fed governors have voiced strong dissent to further quantitative easing, the Fed is universally expected to formally announce “QE2” at the conclusion of this week’s FOMC meeting on Wednesday. Ben Bernanke and other Fed officials have signaled this intention to the markets for two months. The only open question at this point are details of the program – its size and timetable and the degree to which it will conditioned upon economic conditions. Given that expectations of QE2 on a robust scale (i.e. $500 billion or more) have likely been priced into markets, we could be in for a classic case of “sell the fact” after the announcement, especially if the Fed decides on a more cautious, incremental approach. It would be pure conjecture to predict what the FOMC will announce on Wednesday, and how the market will react to the announcement. It is far more prudent to wait until after the fact to assess the announcement and the market’s reaction.

Are there other reasons to expect a fourth quarter correction?

Stocks are overextended after eight straight weeks of gains, and certainly due for a correction. Investor sentiment has become complacent and over-bullish on a short-term basis. For example, the percentage of bears in the most recent American Association of Individual Investors survey slid to 22% -the lowest level in more than three years (Exhibit 1). Our best guess is that an interim peak will be to be established in the next week or two, followed by a 5% to 8% correction.


Exhibit 1


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