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The events of recent days have certainly been bizarre. The capitalist system in which we are operating is supposed to be defined by free markets and democracy. But then I reflect on the past two weeks.

First, investment markets celebrated with great euphoria last Thursday on the announcement that European governments had banned together yet again with dramatic steps of market intervention. This included torturing the rules to make absolutely sure that a technical default was not triggered on Greek debt, effectively rendering an entire asset class in Credit Default Swaps all but useless to many investors. After all, who in their right mind is going to buy insurance when the rules are changed, openly and publicly no less, to make sure that you can’t collect on your policy when the event you're insuring against actually occurs?

Moving ahead to this week, stocks cheered once again when the Greek referendum on the eurozone bailout was cancelled. So let me get this straight. Stocks in the free world sold off sharply on the notion that the people in Greece were being given the chance to have an equal say in a major decision that will be affecting their lives for years, and stocks then rallied sharply once this democratic opportunity was stripped away from them?

Needless to say, these are certainly interesting times when government intervention is lauded and the private markets are feared to act on their own devices without government support or direction.

Of course, these are the forces that define the stock market environment in which we are operating today. The economy and stock market are simply not strong enough to stand on their own. While stocks show signs of sustainable recovery and growth during periods of dramatic monetary policy interventions such as QE1 and QE2, they collapse within days once this support is taken away. And after a mere 38 calendar days following the end of QE2 on June 30, the Fed came back and has been pouring on the stimulus aggressively ever since. First, it was the promise of zero interest rates through mid-2013 on August 9. This intervention helped stem the bleeding and put a floor under the market. Then, Operation Twist was launched just as it appeared stocks were ready to come undone on October 3. This has helped propel the stock market to reverse sharply higher in the weeks since.

(Click charts to expand)

This rally has come in the face of an extremely unstable situation that continues to unfold in Europe. In other words, stock multiples are not contracting in the face of the prospect of slower global growth and the mounting probability of another global financial meltdown at a time when corporate profit margins are already at historical highs at over 3 standard deviations above their historical average. Instead, stock multiples are EXPANDING in this environment with stock prices recently breaking out above their recent trading range. These are interesting times indeed.

So what gives? How can stocks continue to rise in the face of such clear and persistent danger? More aggressive monetary intervention is the answer, as it is the primary driver of this latest gravity defying move by stocks. Operation Twist has propelled stocks higher to this point, and it’s likely to continue to provide a tailwind in the months ahead. And on Wednesday, the Fed effectively confirmed that QE3 is on its way in the coming months, with the only question being exactly when. This is providing stock investors with a tremendous feeling of confidence. Not only is the current boost from Operation Twist flowing in to stocks, but the promise of even more adrenaline from another QE program is waiting in the wings and will be ready for deployment as soon as it’s needed. So no matter how dire the situation becomes, stocks are taking comfort in the fact that the Fed will be there to lend a hand. After all, we’ve seen this story before.

Stock investors may ultimately be taking this sanguine view at their own peril, however. Just like the hospital patient that shows a greater resistance to the medication with each dosage, for with each successive round of monetary stimulus, the associated benefits are likely to become less and less effective. An comparison of the last two rounds of monetary stimulus illustrate this point.

When QE1 was rolled out in early March 2009, the stock market reaction was ecstatic from the very start. Over the next year, stocks rose virtually without interruption and reached new post-crisis peaks at the very end of QE1 on March 31, 2010. They even went on to extend these gains further for the first few post QE1 weeks in April. But then reality set in, and from late April to early July, stocks declined by over -17% before the Fed stepped in with its first signals that more policy help would soon be on the way. But even after this post QE1 decline, stocks were still over +50% above their March 2009 lows.

The results were not as resounding with QE2. Ben Bernanke effectively confirmed that QE2 was on its way in Jackson Hole at the end of August 2010. While stocks rose from this point on, the rate of increase was nowhere near the magnitude seen in the early stages of QE1. By the time stocks reached their QE2 peaks, it was only one-third the gain experienced during QE1. And while stocks were peaking at the very end of QE1, they had already topped out and began pulling back roughly two full months before the end of QE2. Furthermore, stocks endured a more dramatic -22% peak to trough decline after the end of QE2, leaving stocks only +3% above the previous lows set just before QE2 was launched over a year earlier.

Summarizing the contrast between QE1 and QE2, stocks:

  • Rose by significantly less under QE2
  • Peaked far earlier and rolled over under QE2
  • Declined by more once QE2 came to an end
  • And nearly wiped out all of the QE2 gains with this post QE2 decline

While two incidents certainly do not imply a trend, the drop off in the impact of policy stimulus the second time around is notable. And the global economic backdrop was vastly more stable entering QE2 than what we have in the current environment.

Since Operation Twist is already in place and QE3 is likely soon on its way, what can we expect from stocks this time around? The initial response has been joyous, and this upside trend has the potential to continue through the end of the year barring a catastrophic meltdown in Europe, as November and December are both seasonally very strong months for the stock market. This upside is likely to come with greater volatility, however, given the depth of global economic uncertainty particularly from Europe.

It is once we get into January where the outlook becomes more challenged if we get this far. At present, the probability is reasonable that the Fed will launch QE3 in late January, which could provide an added lift to the market. But overall gains are likely to pale in comparison with those of QE1 and QE2, particularly if the European debt crisis continues to deteriorate as anticipated. Moreover, the market peak under any QE3 would likely come much earlier before the end of the program, as the forces of a potential European debt unwind would likely overwhelm the volume of stimulus being pumped into the system by the Fed.

And this is where we get to the “screwed” part of the outlook. The notion of Fed stimulus is the final crutch holding up the stock market. The faith continues to hold that as long as the Fed intervenes with further stimulus, the stock market will be OK no matter what. But if this notion fails and the stock market arrives at a point where it is no longer responsive to stimulus, this final crutch would be forcefully kicked out and the subsequent decline is likely to be severe.

Even if stocks were able to hold steady for the duration of any QE3 program, the likelihood that the economy will have grown to fill the increasingly widening valuation gap is increasingly unlikely with Europe already heading into recession and the rest of the globe facing a deceleration in growth and economic activity. And with profit margins already at record peaks, the likelihood of deteriorating corporate margin compression in such an environment will only add to the pressure to the downside. This implies an even more sharp and staggering decline facing investors than what we have seen in the past once the effects of the Fed's latest stimulus efforts wear off.

So what is an appropriate strategy in such an environment? Fed stimulus is currently driving stocks higher, so adding to current equity allocations has appeal even given the persistent global risks. This does not imply a full on allocation to stocks, however, as the global environment remains far too unpredictable. Instead, stock weightings should be increased deliberately and opportunistically in the context of a still broadly diversified investment strategy across numerous low correlated asset classes. And any such increases in stock allocations should be viewed as short-term and tactical, for once the benefits of Fed stimulus wear off, the subsequent decline is likely to be even more dramatic and severe than past episodes.

Beyond stocks, the more sustainable and attractive investment opportunities continue to reside in other asset classes. Gold (NYSEARCA:GLD) has thrived in an environment marked by ongoing global currency debasement and persistent pricing instability. These influences are amplified even further by each successive round of QE.

Silver (NYSEARCA:SLV) has also demonstrated itself as an investment that is extremely responsive to Fed stimulus having gained over +175% from trough to peak during QE2.

Treasury Inflation Protected Securities, or TIPS (NYSEARCA:TIP), also offer tremendous appeal in the current environment as a consistently strong performer regardless of whether QE is “on” or “off”, as it offers the dual role of inflation protection during times of stimulus and safety during times of non-stimulus weakening.

Finally, Agency MBS has appeal given the apparent policy intentions from the Fed, which essentially announced that large scale MBS purchases would be at the core of any QE3 just as it was with QE1. Given that the MBS market is already relatively small and the Fed already owns a sizeable chunk of it coming off of QE1, opportunity exists with a limited supply asset entering an environment of steady demand from the Fed. Such an approach proved beneficial during QE1.

Bottom Line

The outlook for stocks remains strong as long as Fed stimulus remains in place and markets continue to respond. Risks will continue to be perilously high for equity markets, however, so any such stock positions should be undertaken with a close eye and a tactical view. Fortunately, attractive and more predictable investment opportunities continue to exist outside of the stock market in segments including Gold, Silver, TIPS and Agency MBS. Thus, the ability remains strong to still generate consistent gains in a still turbulent stock market environment.

Disclosure: I am long GLD, SLV, TIP, MBB.

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.