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Our most recent quarterly commentary argues that investors are faced with a major dilemma: whether to speculate that the government will win its bet on rescuing the economy with a massive infusion of new money or to rely on fundamentals that point to a highly fragile economy struggling mightily to grow even moderately. I encourage you to read that commentary as background for the following analysis.

In the eyes of many, Federal Reserve Chairman Ben Bernanke’s Wednesday announcement of a massive second round of quantitative easing (money printing) was the last important arrow in the Fed’s quiver. Consequently, the Fed is doing everything in its power to make this rescue effort successful.

The announcement in late-August that the Fed was again prepared to open the monetary floodgates achieved its purpose exquisitely. The promise of a further monetary infusion put a bottom under stock prices after the worst August since the 1930s and prompted equity speculators to push prices up by more than 14% from those lows to Wednesday’s Fed announcement. That push turned most equity market indexes from negative to comfortably positive for the year-to-date. Despite the market rally preceding the announcement, Wednesday’s actual revelation of the plan’s details spurred traders into action again, pushing the equity indexes up another 3% through week’s end.

Facing opposition from within the Fed’s membership as well as from without, Chairman Bernanke has taken great pains to explain the desirability of a second round of easing after the “shock and awe” first round failed to put the economy on a sustainable upward path. In both Sunday’s op-ed piece in The Washington Post and in a question and answer session Monday with college students, Bernanke ignored the Fed’s normal “quiet period” which normally extends a week beyond the date of a Fed announcement.

Reuters reported Monday from Seoul, Korea that former Federal Reserve Chairman Paul Volcker repeated his skepticism about the benefits of the Fed’s latest quantitative easing. German Finance Minister Wolfgang Schaeuble seconded Volcker’s opinion that QE2 won’t revive growth and added: “With all due respect, U.S. policy is clueless.” Apparently Minister Schaeuble doesn’t believe QE2 is due much respect. China and Brazil also criticized the Fed’s action.

Several weeks ago former Federal Reserve Chairman Alan Greenspan suggested that the most effective stimulus to the U.S. economy would be a rising stock market. In reflecting on the value of the August pre-announcement of Fed rescue intentions, Bernanke referenced the stock market advance as one of the successes of the Fed’s policy approach.

For more than a year, I have speculated on my blog site about the probability of active government intervention in the equity markets. Bernanke has acknowledged rising equity prices as a desired result of Fed policy. Other countries, most recently Japan, have directly supported stock prices.

Our Fed has openly intervened in the fixed income markets. Why not in the equity markets? While we have no explicit evidence of direct government buying, the recent trading patterns would certainly support the presumption of government involvement. Starting immediately after Wednesday’s Fed announcement, buying has come in each time the major stock indexes have broken below even short-term support areas. True investors would not buy there. They would prefer further selling, which would facilitate buying at more attractive prices. Clearly the buyers have not wanted to see technical sellers add to downward pressure. Such buyers need not be government. They could be large trading firms attempting to keep positive momentum alive. There are not, however, too many entities with the buying power necessary to turn markets in their desired direction. And we know that the government wants to keep prices rising.

It has been fascinating listening to floor trader interviews since Wednesday afternoon. Most express serious reservations about underlying economic weakness and about the market’s current overbought and overbelieved condition. Most, however, say they have to be in stocks because the Fed is implicitly “guaranteeing” continuing support, at least for the economy. One trader characterized it as concentrating on the doctor rather than on the sick patient.

I redirect your attention to the dilemma referenced at the top of this post: Should investors bet on government success or on the underlying fundamentals? Clearly government has won round one. Consider carefully, however, whether you could withstand losses that could occur rapidly in most asset classes if confidence wanes and government efforts appear unsuccessful.

Disclosure: No positions

Source: Is the U.S. Government Buying Stocks?