Where Will Stocks Go After QE2? The Fed's Balance Sheet Holds the Key

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Includes: DIA, FXE, IVV, QQQ, SPY
by: Eric Parnell, CFA

The Fed’s QE2 stimulus plan comes to an end on June 30. This is a fact that is certainly not lost on investment markets. It is widely known how negatively stocks reacted when QE1 came to an end during the spring of 2010. And amid an increasingly weakening economy and the threat of a European sovereign debt crisis, many are also anticipating the same outcome for stocks this time around. In working to assess whether we’ll see another precipitous decline in stocks, it is important to consider the timing of when it all might begin to break. The key is not necessarily the day QE2 ends. Instead, the inflection point is likely to arrive once the Fed’s balance sheet finally tops out.

The stock reaction to the end of QE1 was severe. The market as measured by the S&P 500 Index touched a post crisis intraday peak of 1219 on April 26, 2010. In the next 47 trading days over the next eight weeks, the stock market plunged by -17%. During this stretch, down days outnumbered up days by 2-to-1. Volatility also increased dramatically, with stock market moves of more than +/-1% nearly 60% of the time. This included 11 trading days with moves over +/-2% and 6 trading days with moves in excess of +/-3%. And this stretch also included the infamous “flash crash” on May 6 when the market plunged intraday by nearly -9% in minutes before recovering to end the day still down -3% from its previous close. Based on this past experience alone, investors are right to be wary of stocks as we approach the end of QE2.

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Click to enlarge

It’s worth noting that QE1 did not end on April 26, 2010. Instead, it had technically ended roughly three weeks earlier on March 31, 2010. Thus, the stock market continued to rally higher for a full 17 trading days after QE1 had ended before finally peaking. This final climb was virtually uninterrupted, with 14 up days versus only 3 down days from April 1 to April 26, 2010.

So with all of this anxiety over the end of QE2, what accounted for this continued stock rise for several weeks after the end of QE1?

The answer – the continued growth of the Fed’s balance sheet. Even though QE1 technically came to an end on March 31, 2010, the Fed continued to expand its balance sheet by another $30 billion through the first few weeks in April. Thus, additional stimulus was finding its way into capital markets including stocks.

Watching the Fed’s balance sheet will be important in attempting to time any post QE2 decline in stocks. Instead of rising into the end of QE, stocks have been declining for several weeks this time around. Clearly, investors have anticipated the end of QE2 on June 30 and have begun positioning in advance. But the continuing stimulative effects of QE remain evident in the market even despite the recent pullback.

It would have been reasonable to expect a much steeper downside since early May in today's stock market without the support of QE2. As discussed in my recent post Stock Correction May Have Much Further to Go, the stock market is currently 34% overvalued. Such froth would leave stocks exposed to the potential for a substantial correction even in a calm market.

Of course, today’s market backdrop is hardly placid. To the contrary, it’s quite troubling. Economic conditions have deteriorated considerably in recent months, raising the danger once again of a double-dip recession. And Europe remains on the brink of a sovereign debt crisis that many suggest could equal or exceed the magnitude of the Lehman collapse in late 2008. Given this backdrop against lofty valuations, its remarkable that we’ve experienced only a -5% to -6% decline since the recent April 29, 2011 peak through yesterday. Clearly, the ongoing support of QE2 has helped pad the damage.

Watching for the flattening of the Fed’s balance sheet is critical. If the Fed continues to expand its balance sheet after QE2 ends, we are likely to see further support for stocks. Moreover, if the Fed were to engage in any stealth QE3 as some have recently suggested, this may be one way to monitor if such activity is taking place.

Through it all, it stands to question what will become of the stock market once this balance sheet support eventually goes away. My belief is that the move will be much further and much faster to the downside. And the key catalyst to when this all happens likely resides with the flattening of the Fed’s balance sheet.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: 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.