Nothing is more desirable than to be released from an affliction, but nothing is more frightening than to be divested of a crutch.
~ James Baldwin
There's been no shortage of potentially market-moving news for investors to digest so far in 2011. From major geopolitical strife in the Middle East to the sovereign debt crisis in Europe to the multilevel Japanese catastrophe, markets have been remarkably resilient so far. Perhaps that's because these types of events aren't what's driving the markets.
The only news items that seem to have any lasting impact on the stock and bond markets these days are those that pertain to monetary policy, particularly that of the US Federal Reserve. David Rosenberg recently pointed out that there has been an 86% correlation between the Fed's balance sheet and the S&P 500 over the last 2 years. So it seems logical that the biggest question facing investors these days relates to the possible next steps for Ben Bernanke and company. Specifically, investors and analysts are speculating about what happens when QE2 ends in June.
The QE Quartet
As always, there's no shortage of opinions on what will happen in a couple of months when QE2 is over. There are plenty of smart people offering polar views on whether QE has been effective, whether it should continue, and what the market reaction will be. Last week, Mohamed El Erian of PIMCO was on TV saying that QE1 was absolutely necessary, QE2 was unnecessary, and QE3 would be a disaster.
While the spectrum of opinions on QE is extremely varied, you can roughly divide the field into four groups along two axes. The first axis is those who believe QE is a good thing versus those who think it's a bad idea. The second is those who think QE will cause the markets to rise versus those who think it will, at some point, cause a stock and/or bond market correction at best, and a crash at worst.
Let's take a look at each of these four groups, bearing in mind that there are many views in between as well.
1. QE Is Good, Markets Will Rise
Obviously, this is pretty much the view of the Federal Reserve itself. While they acknowledge that quantitative easing is an unconventional monetary tool, they contend that it is necessary to combat the deflationary forces brought on by the recent financial crisis. They believe the policy will (and has) helped the real economy by stimulating asset prices and generating a wealth effect whereby consumers and businesses feel more confident and subsequently boost the economy through increased hiring and spending.
2. QE Is Good, Markets Will Fall
This group believes that QE was necessary to prevent a collapse of the financial system and that it has successfully levitated asset prices. It has bought us some time to try to heal balance sheets and get the economy moving under its own power. These folks, however, have their doubts over whether or not we've actually done what's necessary to clean up the problems that caused the financial crisis. In fact, the IMF itself recently expressed some doubts on that score. If the root causes of the crisis are not addressed, then the economy and the markets will falter once the QE crutch is removed.
3. QE Is Bad, Markets Will Rise
This is an interesting view that was recently articulated in a guest post by Darwin at Investor Junkie. The article posits that the real reason you should be bullish on stocks has nothing to do with the strength of free market capitalism and everything to do with asset-goosing monetary policy. Darwin, like many others, has been a "reluctant participant" in the rally, and believes it will continue for a while longer. But he sees the huge US debt burden coming home to roost in the form of rising interest rates in the next few years.
Other variations on this view see QE as ethically questionable as it tends to help those who benefit from rising asset prices while it hurts savers who are struggling to earn a decent rate of return in a record low interest rate environment . The wealthy, banks, and large corporations tend to be in the former group, while lower/middle income folks and small businesses tend to populate the latter. Jim Rickards has labeled this policy of bailing out banks at taxpayers' expense "immoral hazard" and Joseph Stiglitz recently lamented the growing wealth disparity in America due to fiscal and monetary policies of the 1%, by the 1%, for the 1%.
4. QE Is Bad, Markets Will Fall
One of the most vocal critics of Federal Reserve policy has been David Stockman, former OMB director under Ronald Reagan. He has written about crony capitalism and the Federal Reserve's path of destruction, using terminology like "preposterous", "dubious" and "bubble-making" to describe QE2 and ZIRP. Stockman contends that these policies merely inflate bubbles that inevitably pop and cause economic and market crashes:
The fact is, if transitory wealth effects add to current consumer spending, they can just as readily subtract on the occasion of the next “risk-off” stampede to the downside. Indeed, the proof — if any is needed — that cheap money fueled asset inflations do not bring sustainable prosperity lies in the still smoldering ruins of the US housing boom.
Likewise, Kyle Bass of Hayman Advisors has highlighted the cognitive dissonance in which investors are currently engaging:
They acknowledge that excessive leverage created an asset bubble of generational proportions, but they do everything possible to prevent rational deleveraging. Interestingly, equities continue to march higher in the face of European sovereign spreads remaining near their widest levels since the crisis began. It is eerily similar to July 2007, when equities continued higher as credit markets began to collapse.
He sees the ZLB (Zero Lower Bound) as a trap. Many countries, including the US and Japan, cannot afford to leave the ZLB because of the tremendous amount of debt they are servicing. But bond markets may force rates higher, causing massive disruptions in the credit and currency markets. So far, this "X Day" hasn't happened, but Hayman and others think it's coming.
Who's Right and What Can Investors Do about It? It seems to me that it's possible that each of these perspectives may be correct at some point. The differential may simply be a matter of timing. QE2 may appear to be a good thing in the short term, but its longer term consequences are far from clear and may end up causing a good deal of pain in the markets as well as the real economy.
If any or all of these perspectives end up playing out as QE2 ends, how should investors react? David Rosenberg suggests we look at what happened to the markets last year as QE1 was about to end: the S&P 500 fell, defensive sectors like utilities, telecom services, consumer staples and health care performed best. Tech, financials, energy, commodities, and consumer discretionary sectors underperformed. The US dollar firmed while 10 year yields fell.
It's important to note that all of the above trades reversed pretty hard once Mr. Bernanke and company started telegraphing QE2 in August of 2010. Will the same thing happen again if QE3 looks possible? Probably.
But how likely is QE3? Most observers seem to think that QE3 is not necessary at the moment, but we heard the same thing about QE2 as QE1 wound down. Once the markets and economy started to falter last spring and summer, everyone seemed to change their minds very quickly, proposing that QE2 was necessary to juice the markets and thereby support the economy.
Will 2011 be a replay of 2010 with markets pulling back in the spring and summer only to be pushed higher in the fall by another round of quantitative easing? Or will bond markets finally say enough is enough?