QE and the Damage Done to the Market

by: Eric Parnell, CFA

I’ve seen quantitative easing and the damage done to the stock market over the past two years. And now that the monetary drugs are mostly gone, the withdrawal may soon become acutely painful for investment markets.

When the financial crisis struck in late 2008, markets were consumed by a sense of hopelessness that the financial system could be saved and descended into extreme volatility and extended phases of panic selling. But along came the Fed with a fix for the markets. Starting in March 2009, the Fed began injecting the markets with a sustained dose of quantitative easing (QE). A sense of relaxation and euphoria quickly set in that all was now better for the economy and the markets. And for the next two years, stocks floated higher, free from the constraints of the material world. The economic recovery remains sluggish? No matter. Dubai can’t pay its debts? No matter. Corporate profits are rising due largely to cost cutting? No matter. Debt and deficit levels in the United States are increasing to unprecedented levels? No matter. The euro currency may soon be torn apart by the potential insolvency of several member nations? No matter. As long as the market had its QE fix, everything was all right.

A little part of it was in everyone. Whether you were an investor who fully believed that everything would eventually get better or someone who thought it was all just a grand façade fueled only by extremely aggressive monetary stimulus, you more than likely got back into the stock market. After all, if the Fed was determined to send investment markets floating on QE, you almost had to get on board and go along for the ride even if you knew at some point it was going to end badly.

QE junkies may now be setting in the sun. With the latest dose of QE now gone from the market as of June 30, stocks are increasingly suffering from a sense of anxiety and depression. Greece may default on its debt? This sounds like a problem. The European Union has to come with yet another massive rescue plan? This is not good at all. We’re less than two weeks removed from this latest rescue plan and pressures are already mounting on both Spain and Italy (10-year yields rose another 8 bps (6.28%) and 13 bps (6.13%), respectively on Tuesday)? This is really bad. We’re nearly three years removed from the financial crisis and we’re facing the threat of another global contagion? Maybe it’s time to panic. Evening may be quickly turning to nighttime in the QE withdrawal process if the recent correction continues to pick up steam.

(Click charts to expand)

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The damage caused by QE is the following. I do not dispute the need for the Fed to aggressively intervene at the beginning of the financial crisis. Something dramatic needed to be done to stabilize the global financial system. However, by continuing to inject markets with QE for years after the fact, it has caused the market to levitate to unsustainable levels of overvaluation. Had the Fed let markets function on their own, particularly after the end of QE1, stocks would have likely found the way back toward fair value, which based on long-term average historical valuations would currently imply an S&P 500 (NYSEARCA:SPY) in the 950 to 975 range. After all, stocks were quickly making their way to these levels at the end of June 2010, before the first rumblings of QE2 started to swirl in the market place. Instead, with the subsequent injection of QE2 and another euphoric float in stocks, we’re now looking at the prospect of a market that could easily correct by -25% or more from current levels in the coming weeks now that the effects of QE2 appear to be wearing off. And what damage will that do to already shaky investor confidence in markets? Nothing good to be sure.

So where do stocks stand today in the QE withdrawal process? Clearly, cold sweats and a general feeling of heaviness have set in. Stocks are now down for eight straight trading sessions. On Tuesday, the S&P 500 decisively broke through critical support at the 200-day moving average. This was the first time stocks have traded below the 200-day M.A. since before QE2 was essentially announced in August 2010. Stocks quickly dropped toward their next major support level by Tuesday’s close. This is the range on the S&P 500 between 1249, which was the intraday low reached on March 16, 2011, and 1258, which was the level at the end of 2010. Thus, we are now at a critical juncture for markets.

The next few of days will be vital in determining whether the markets can get clean or if more feelings of withdrawal are in store for fall. First, a break below current 1249-1258 support levels would not be a surprise given the weakening economy and the deepening crisis in the Euro Zone. The next major support level would come in the 1219-1227 range, which marked the QE1 peak and previous resistance in the early stages of the QE2 rally. From there the next stop would be around 1130. On the flip side, it would not be surprising at all to see stocks bounce solidly off the current 1249-1258 support level and reclaim the 200-day moving average, particularly since a lot has come off the stock market in a very short period of time. However, any such rally may be short-lived given the troubling global economic backdrop and the lack of any more QE dope coming soon (at least for now).

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So what is the best way to capitalize on these recent developments? If you’re invested in precious metals including Gold (NYSEARCA:GLD) and Silver (NYSEARCA:SLV), you’ll likely be best served to stay the course. The weakening global economy and the inclination for further currency debasement are supportive of these hard asset safe havens. Of course, short-term corrections in these metals should not be ruled out, but these can likely be used as opportunities to add to existing positions. Treasuries (NYSEARCA:IEI), (NYSEARCA:IEF), (NYSEARCA:TLT), (NYSEARCA:TIP) should also continue to perform well given the economic environment, although the recent sharp drop in yields (and sharp rise in prices) suggests that we could see some consolidation of recent gains and perhaps even a pullback in the coming days. Depending on the depth of any pullback, this may also provide the opportunity to add to positions. Lastly, some high quality stocks have been crushed along with the market in the QE detox process, so it may be worthwhile to scan for the opportunity to pick up some solid defensive stock names at attractive valuations as they present themselves. I'll be looking to check back with a few in the coming days.

Of course, a key variable in the market outlook is the potential for the Fed to begin talking about QE3. I will be writing about this in more detail including its potential effectiveness in a second part to this article tomorrow. In the meantime, be careful out there in the market.

Disclosure: I am long GLD, IEI, IEF, TLT, TIP.

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.