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The latest minutes from the August 9 meeting made it rather clear: The Fed will be quick to act with additional stimulus at a moment's notice when deemed necessary. While I disagree with such a reactive policy approach by the Fed and would rather see no additional action unless absolutely essential, when it comes down to it, my opinion doesn’t really matter since I am not a voting member of the FOMC. The reality is that further Fed stimulus is likely to be coming sooner rather than later, so it is important to explore the potential impact on investment markets. And for stocks, the key to further gains all comes down to plans for the balance sheet.

The Fed certainly earns high marks for the Fed's well-honed communications effort. Send out hawks Fisher and Plosser ahead of Jackson Hole to manage expectations lower about QE3. Stocks thrash. Send out Bernanke at Jackson Hole to wag his finger at Congress, crack the QE3 door by stating openness to all options and focus all eyes on the September 20 policy meeting by tacking on an extra day. Stocks cheer. Send out dove Evans after Jackson Hole to stoke hopes for QE3 on September 20. Stocks swoon. Send out onetime hawk but suddenly now dove Kocherlakota saying he would not dissent again at the next meeting. Dance, markets, dance.

The Fed and the Fed's ubiquitous voting members are clearly working hard to prep the markets for a potential new round of stimulus to be announced on September 21. And given all of the events that could potentially unfold over the next three weeks – more U.S. economic data and crisis in Europe coming to a head – additional policy measures might even have greater justification than they do now.

But for stock investors, whatever the Fed announces as part of a QE3 program will come down to one key question: Will the next round of monetary policy stimulus include an expansion of the Fed’s balance sheet? This is an absolutely critical point, for what helped stocks levitate beyond all comprehension throughout QE1 and QE2 was the billions of dollars of additional money that the Fed was pumping into the system each day through the Fed's asset purchases. If the balance sheet isn’t expanding, stocks may lack the fuel this time around to continue rising.

A look back over the last few years illustrates the following two points: When the Fed was expanding its balance sheet through QE, stocks rose almost without interruption; when the Fed stopped expanding the Fed's balance sheet, stocks would quickly fall into decline even though policy remained highly accommodative.

During the period from March 2009 when QE1 was fully engaged until mid April 2010 when the Fed stopped expanding the Fed's balance sheet after the end of QE1, stocks rose in lockstep.

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But the moment the Fed stopped expanding the Fed's balance sheet post-QE1, stocks quickly began to fall sharply.

After foreshadowing QE2 for much of July and August, stocks began to rally following Fed Chairman Ben Bernanke’s Jackson Hole speech, essentially confirming that further balance sheet expansion was soon on its way.

Predictably, once the Fed stopped expanding the Fed's balance sheet post-QE2, stocks quickly descended back into a sharp decline.

This strong post-crisis relationship between the Fed’s balance sheet and stocks is important to keep in mind when evaluating the details of any QE3 stimulus plan from the Fed in the coming months. While the Fed has mentioned the possibility of more Large Scale Asset Purchases (LSAP) that would lead to balance sheet expansion, the other potential plan involving the increase of the average maturities in the Fed’s portfolio would not. Nor would a reduction on the interest paid on excess reserves. Thus, if the Fed is not expanding its balance sheet with a new QE3 program, stocks may not have sufficient fuel to levitate higher the next time around.

I would consider further LSAP to be a lower probability outcome from the Fed this time around for several reasons. First, the Fed’s decision to support asset prices including stocks provided little to no sustained economic benefit emerging from QE2. Instead, it drew criticism to the Fed. Second, the Fed now has a rising inflation problem to navigate, so the Fed may be inclined to avoid another round of LSAP that resulted in spiking commodity prices under both QE1 and QE2. Third, despite the intent to keep borrowing costs low with QE, interest rates on U.S. Treasuries actually rose rather sharply under QE and fell without it. Lastly, the Fed has gone down the LSAP road twice and will likely not want to be seen trying to repeatedly take the same policy approach without success. As a result, the Fed will likely be inclined to take a different fresh approach this time around, particularly given some understandable reluctance to expand the balance sheet any further than the Fed already has.

So what asset classes would potentially benefit most under a QE3 scenario with no further balance sheet expansion. While stocks and commodities would likely move sideways, categories such as U.S. Treasuries and precious metals including gold and silver would be well positioned to continue rising. Of course, the key will be in the details if and when the Fed finally decides to act. The next several weeks should be very interesting in leading us to this verdict.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management 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.

Source: QE3: The One Detail That Stocks Will Need To Benefit