What to Expect From QE2's Pending Conclusion

by: Eric Parnell, CFA

"The higher you climb, the harder you may fall."

Fundamentals have not mattered. Technicals have not mattered. Instead, since the days following the outbreak of the financial crisis, the stock market has moved in lockstep with the massive $1.7 trillion expansion of the Fed's balance sheet (see chart). When the Fed is actively engaged in asset purchases (QE1, QE2), the stock market rallies. And when the Fed is not buying assets (Spring/Summer 2010), the stock market plunges.

Nothing else seems to matter but the Fed. European sovereign debt crisis, Middle Eastern social unrest, soaring commodities prices and a sluggish economy are all ignored due to the intoxication of freely flowing money from the Fed each day. A market that has risen on little more than air for two years is troubling, to say the least.

[Click to enlarge]
Click to enlarge

Over the last several days, the Fed has expressed with increasing swagger that it will bring QE2 to an abrupt end when it expires in June. Whether they are still so bold come June remains to be seen, but taking the Fed at their word today, what can we expect from investment markets once it all comes to an end?

To begin with, those that suggest that stocks can continue to rally without more QE are misguided. Sure the economy has recovered from the depths of the crisis, but stocks already reflect any recovery we've seen so far and a lot more. We would need to see economic activity pick up dramatically in the next few months to even begin to start supporting stocks at current valuations. This is very unlikely.

As a result, the outlook for stocks is poor once QE ends in June. What type of correction can we expect? Fortunately, the end of QE1 provides some insight. QE1 ended in April 2010, and the stock market quickly plunged by 17% in just 10 weeks, into July 2010. And stocks would have likely fallen further had the market not begun to speculate that QE2 was coming around the corner.

Today, the market is 10% higher than it was at its peak in April 2010 at the end of QE1, so we should expect the magnitude of the correction at the end of QE2 to be easily -20% or more.

What about timing? The stock market decline last time around was coincident with the end of QE1. This time around, many are anticipating the stock pullback at the end of QE2, so we should expect a move to the exits that slowly begins to creep in at least a few weeks in advance.

So where will the money flow? Last time around, the money flowed out of stocks and into safe haven assets including U.S. Treasuries, investment-grade corporate bonds, gold, the U.S. dollar and volatility. Whether we see the same money flow trends at the end of QE2 is subject to debate, but is the key to the puzzle in generating returns in the second half of 2011 (or until the Fed opts to step in with QE3). This is a topic I will be dissecting and exploring in more detail in future posts over the coming weeks.

In the meantime, the float higher in stocks appears likely to continue, risks be damned.

Disclosure: I am long LQD, GLD.