Two and a half months. This is how long the initial stock market rally has run before falling into correction during periods when the U.S. Federal Reserve has been actively engaged in a daily balance sheet expanding monetary stimulus program. The latest such program - daily U.S. Treasury purchases as part of the Fed's QE3 program - got underway on January 4. And as we move through 2013, we have now arrived at the two and a half month mark in the coming week. Will the same pattern repeat itself for stocks once again this time around? And if the stock market does indeed pause or fall into correction, into what other asset classes can we expect capital to flow? While a sample size of two is clearly insufficient to draw any firm conclusions, it is worth at least a look at the periods of daily U.S. Treasury purchases during past QE programs to see if what similar patterns may be developing once again this time around.
In exploring this topic, we will examine the performance of the major asset classes during both the past and current round of balance sheet expanding monetary stimulus. Asset classes included are those that have generally low to negative correlations with most other major categories. This is done to explore the potential portfolio diversification benefits within the context of these monetary stimulus programs. These categories are found in the following chart.
QE1 - March 2009 to March 2010
The analysis begins by examining the Fed's QE1. The daily asset purchases under this program got underway in mid March after the Fed expanded its program to include $300 billion in U.S. Treasury purchases. This, not coincidentally, was right around the time that the post crisis market bottom was set. During the two and a half month period from late March to early June, we experienced the following returns across asset classes (various sub asset classes have also been included to expand the illustration):
QE1 - First two and a half months (late March to early June 2009)
+21.30% - U.S. Large Cap Stocks (SPY)
+29.67% - Developed International Stocks (EFA)
+39.27% - Emerging Market Stocks (EEM)
+20.89% - High Yield Bonds (HYG)
-2.31% - Gold (GLD)
+9.02% - Silver (SLV)
-0.59% - U.S. TIPS (TIP)
-0.10% - U.S. Bonds (AGG)
+6.19% - U.S. Investment Grade Corporate Bonds (LQD)
-13.12% - Long-Term U.S. Treasuries (TLT)
This was clearly a swift risk on rally in the early stages of QE1. Stocks around the world exploded higher along with highly correlated categories such as high yield bonds. But most other remaining categories languished including gold, bonds and long-term Treasuries. But for the remainder of QE1 after these first two and a half months, these returns became much more balanced:
QE1 - Remainder of the program (early June 2009 to end of March 2010)
+25.51% - U.S. Large Cap Stocks
+19.12% - Developed International Stocks
+26.90% - Emerging Market Stocks
+19.04% - High Yield Bonds
+18.21% - Gold
+17.16% - Silver
+6.31% - U.S. TIPS
+6.38% - U.S. Bonds
+11.15% - U.S. Investment Grade Corporate Bonds
+2.46% - Long-Term U.S. Treasuries
Over this remaining time during QE1, liquidity was flowing everywhere as confidence was gradually being restored. And since most assets offered attractive values at this stage, the potential for upside was virtually everywhere in varying degrees. But the gains that were once so heavily focused on stocks during the early part of the program were more evenly spread across all asset classes for the remainder.
QE2 - November 2010 to June 2011
By the time QE2 was officially announced in November 2010, the global economy had been pulled back from the brink and the returns opportunities available to investors had become more narrowly defined. It is worth noting that it took roughly a half a month after the launch of QE2 and its $600 billion in U.S. Treasury purchases in mid November before the QE2 market ramp kicked off on the first day of December 2010.
QE2 - First two and a half months (early December 2010 to mid February 2011)
+12.52% - U.S. Large Cap Stocks
+8.81% - Developed International Stocks
+0.61% - Emerging Market Stocks
+4.85% - High Yield Bonds
+1.29% - Gold
+24.57% - Silver
-2.68% - U.S. TIPS
-1.51% - U.S. Bonds
-0.95% - U.S. Investment Grade Corporate Bonds
-5.61% - Long-Term U.S. Treasuries
Stocks once again led the performance charge over the first two and a half months. But returns across asset classes were far more subdued than they had been under QE1. While U.S. large cap stocks performed well, developed international stocks lagged and emerging market stocks were effectively flat. The pace of high yield returns had also slowed notably. And while the precious metals fared well despite some wild swings in volatility along the way, bonds were modestly sold off. But all of this changed once we reached the two and a half month inflection point.
QE2 - Remainder of the program (mid February 2011 to the end of June 2011)
-0.99% - U.S. Large Cap Stocks
-1.00% - Developed International Stocks
+3.81% - Emerging Market Stocks
+1.35% - High Yield Bonds
+7.82% - Gold
+6.45% - Silver
+6.31% - U.S. TIPS
+3.08% - U.S. Bonds
+3.46% - U.S. Investment Grade Corporate Bonds
+6.77% - Long-Term U.S. Treasuries
The performance tide shifted dramatically for the final four and a half months of the QE2 program. U.S. large cap stocks suddenly ground to a halt, posting a negative return along a volatile path for the remainder of QE2 that included two separate -7% corrections along the way. Developed international stocks also struggled. And while emerging market stocks finally came to life, returns were generally modest. Instead, the fresh liquidity that was once finding its way into stocks had changed its preferences decisively toward precious metals and bonds.
QE3 - January 2013 to ???
So where do we stand today? The Fed launched its latest daily U.S. Treasury purchase program at the beginning of January at a rate of $45 billion per month. Unlike past QE programs that had a defined end date, the current program is set to continue to infinity or until the Fed decides that the economy has sufficiently healed, whichever comes first. Of course, the Fed may also find itself forced to end the program early due to forces beyond its control, but that is a subject for another article. But the behavior of markets has once again followed a similar pattern as we approach the notable two and a half month marker in the program.
QE3 - First two and a half months (early January 2013 to today)
+6.60% - U.S. Large Cap Stocks
+3.64% - Developed International Stocks
-2.44% - Emerging Market Stocks
+1.13% - High Yield Bonds
-4.64% - Gold
-4.13% - Silver
-0.43% - U.S. TIPS
-0.44% - U.S. Bonds
-0.78% - U.S. Investment Grade Corporate Bonds
-2.56% - Long-Term U.S. Treasuries
Several points warrant attention this time around. First, despite all of the fuss in the media about how great things seem in the markets right now, results have been lackluster at best and lousy at worst outside of U.S. stocks. Second, the market returns generated by each successive round of daily balance sheet expanding monetary stimulus from the U.S. Federal Reserve is having an increasingly diminishing impact. In short, the additional liquidity being injected into capital markets is having less of an influence on asset prices, and the preference of this liquidity is becoming more narrowly defined. Today, the asset class of choice is U.S. stocks, but for how long, particularly given the weak underlying fundamentals that currently exists under stocks.
So as we arrive at the two and a half month inflection point for the latest QE3 stimulus program, it is reasonable to consider two key points.
First, will stocks continue to move higher as they did under QE1? Will they stumble into a volatile sideways churn as they did under QE2? Or could they actually begin to move sustainably to the downside? Given the already more subdued impact on stocks to this point coupled with recent fundamental and technical data suggesting the current rally is showing mounting signs of fatigue, probabilities are biased toward some of the less desirable outcomes for stocks. But when the Fed is involved in trying to juice asset prices including stocks, all bets are off in the end. And the notion of even thinking about shorting stocks in the current environment is downright treacherous regardless of the evidence that may support such positioning at any given point in time. With this being said, when stocks have entered into correction during the post crisis period, they do so swiftly and sharply with the potential for a double-digit decline in the matter of days always meaningful possibility. For this reason alone, caution remains warranted when it comes to dealing with stocks even despite their recently strong run.
Second, if we do indeed see a change in preference going forward on how the new liquidity that is being injected daily into the markets is allocated, exactly what asset classes are we most likely to see this capital shift toward?
In an upcoming article, I will explore the current investment opportunities across the various major asset class including stocks in an effort to determine what categories might show renewed or continued signs of life as they have during the latter stages of past QE programs and what categories are likely either to grind to a halt or struggle going forward.
This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.
Additional disclosure: I am currently long stocks via MDY, SPLV, FXI, XLU and selected individual stocks. I am currently long precious metals via GTU, CEF, PSLV and SLW. I am currently long the long-term bond market via BAB.