What If This Is As Good As It Gets For The Stock Market?

by: Eric Parnell, CFA

Have we finally reached the end of the line for stocks in the current cycle? After over three years of unprecedentedly aggressive monetary policy injections, is this as good as it gets for the stock market? The events of the past week raise concerns that we may be soon approaching the point where the stock market may finally no longer meaningfully respond to further stimulus.

Two notable events came to pass in the past week in support of this possibility.

The most significant one came from the Fed. In what has become a far too predictable occurrence, the Fed offered up yet another policy response to try and jump start the economy and markets. Less than six months after announcing that interest rates would remain at 0% until mid-2013, the Fed emerged from their latest two-day session with an extension of this commitment by another year and a half through late-2014. They also tacked on an explicit 2% inflation target and introduced individual forecasts from each of its 17 members. And placing a cherry on top, the Fed continued to dangle the prospect of providing yet another round of QE the moment it is needed.

The latest Fed policy action and post meeting show raises some key points of concern. To begin with, the Fed's expanding communications barrage is quickly tumbling toward overkill. And in many respects, it is increasingly a hint of a committee that is now simply trying too hard. This leads to the next logical question of exactly why? For a committee that until recently operated quietly behind the scenes and required a Fed Speak-to-English dictionary to interpret carefully expressed views, what is behind their sudden loquaciousness? Is the once mighty Fed becoming a paper tiger? Are they trying to influence markets with words simply because their monetary policy arsenal is running on empty? And are investment markets starting to wake up to this possibility?

The Fed's potential loss of policy as a tool to influence markets raises another issue that is perhaps far more critical for the outlook. Since the beginning of the financial crisis, the one thing we could always count on from the Pavlovian markets was an immediately euphoric response from stocks (NYSEARCA:SPY). All the Fed has needed to do, even in recent months, was to throw out just about any policy prescription and the market would lap it up in celebration.

Not so this time around. The Fed put on their grandest communication production yet this past week filled with all of the goodies that stocks should love. Yet all the stock market had in it this time around was a fleeting intraday upside reversal on Wednesday that was almost completely given back by the end of the week. It has only been a few days since the Fed press conference, so the initial reaction could certainly change in the coming week, but it appears the Fed's latest policy action may have been a flop for the stock market, as the three or more big white candles that typically follow such Fed generosity were nowhere to be found this past week.

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Now some might argue that the latest Fed policy action was deployed on a market that has been rising sharply for several weeks already. This marks a clear differentiation from the timing of other recent Fed policy actions, all of which arrived as the market was in the midst of cascading lower. Perhaps this explains the lackluster response by stocks this time around. But stocks are now standing at an important juncture in their move to the upside, as they have just arrived at the price levels that existed just before the major sell off in late July 2011.

This latest stimulus boost could have easily been the needed jolt to break out above this resistance level and thrust stocks to new post crisis highs. Thus, the fact that stocks received virtually no lift at all is disconcerting, particularly since the Fed can offer up these stimulus injections so many times.

Others might contend that the markets may not have viewed the Fed's latest policy action as further stimulus and this is why stocks did not respond. Indeed, stocks responded quite negatively at first to the announcement of Operation Twist in September and only began rallying sharply higher once the program was launched in early October. But such market oversight does not appear likely this time around. Whereas both gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) responded in similar fashion to stocks by plunging lower following the Operation Twist announcement in September, the yellow and white metals both exploded sharply higher from the moment the Fed began speaking this week. Clearly, broader investment markets are expressing no doubt that this latest Fed action represents further stimulus.

The Fed faces a critical dilemma if the stock market were to begin ignoring its policy actions. This is due to the fact that the primary force that has been driving stock prices higher since the outbreak of the financial crisis several years ago is generous monetary easing by the Fed. As long as the Fed is stimulating, stocks have risen. And literally the moment the Fed has stopped stimulating along the way, stocks immediately cascade lower. Thus, a key driver of stock price elevation at any given point in time is the hope for ever more monetary policy injections from the Fed.

As long as the Fed is either giving the market its monetary fix or stands at the ready with another injection, stocks have stood poised to lift higher. So if stocks suddenly stop responding to Fed stimulus, the last bastion of hope supporting the stock market may quickly evaporate. And all of those investors reliant on perpetual monetary largesse from the Fed to justify maintaining their stock positions, the disappearance of this driving force may be the signal that it's finally time to head to the exits. After all, if the stock market is no longer responding to Fed stimulus, what else does it have to drive further gains from here, much less protect against staggering losses?

This troubling prospect leads to the second important point from the week, which was the surprisingly disappointing reading on Q4 U.S. GDP. A theme that had been gaining support in recent months was the idea that the U.S. economic recovery was picking up speed. As a result, expectations were high for a strong growth reading for the fourth quarter of 2011. And even if the economy were not strengthening sustainably, surely the accelerated depreciation fiscal stimulus program that was set to expire at the end of 2011 provided what would at least appear like a burst in economic activity toward the end of last year. Even someone like myself that has remained generally bearish on the near-term economic and market outlook was expecting a fairly strong Q4 U.S. GDP reading for these reasons, as my concerns rested more on the sustainability of this growth into 2012.

So when the latest reading on quarterly GDP came out disappointingly weak on Friday, it raised some serious questions about the outlook going forward. If this is as good as the U.S. economy could muster at the end of 2011 with the wind in many ways at its back, what will 2012 bring as Europe falls into recession and the demand that was pulled forward into 2011 disappears from 2012. Unfortunately, the most likely outcome is renewed concerns about the U.S. economy falling back into recession.

Thus, if the economic outlook proves disappointing and Fed policy starts to become ineffective, the stock market may be left without any major catalysts to drive it higher from here. Furthermore, the stock market may even begin to feel increasingly uncomfortable at these price levels. All of this implies a stock market that may at best be set to increasingly grind at current levels or perhaps even begin to move lower from here.

So is this as good as it gets for the stock market? The answer remains to be seen. Perhaps the stock market response has been delayed and will pick up next week. And the Fed still holds in its hand the QE3 trump card, which may be the bigger juice now required by the markets to get a response from here. But if we have finally reached the juncture where stocks are no longer responding to the Fed's monetary adrenaline, the subsequent market fallout could be severe.

What is an investor to do given such prospects? The priority in the current environment remains staying hedged. Maintaining an exposure to stocks is worthwhile, particularly to ensure portfolio participation to the upside if it turns out that stocks are still responding to stimulus. But focusing this stock exposure toward more defensive sectors is worthwhile in managing the potential downside risk.

Moreover, emphasizing yield in stock selection is also sensible to help generate upside in a sideways grinding market and to help buffer losses in a downward sliding market. Representative names in this regard include Kellogg (NYSE:K), HJ Heinz (HNZ) and Alliant Energy (NYSE:LNT). Adding positions to McDonald's (NYSE:MCD), Hershey (NYSE:HSY) or Bristol Myers Squibb (NYSE:BMY) on pullbacks may also be worth consideration.

The good news is that attractive opportunities continue to exist beyond the stock market. Leading among these is gold and silver, both of which have been lagging while stocks have been on a stimulus bender since early October. After bottoming at the very end of 2011, both precious metals are showing increasing signs of life and still have considerable room to move to the upside, particularly in an environment where global central banks appear determined to continue stimulating aggressively at all costs for the foreseeable future.

More defensive positions such as U.S. Treasury Inflation Protected Securities (NYSEARCA:TIP) and Agency MBS (NYSEARCA:MBB) also offer appeal. TIPS are attractive in that they offer both protection against inflation as well as a safe haven in the event of a market crisis. And Agency MBS offer what is effectively an explicit backing from the U.S. government, an attractive yield relative to U.S. Treasuries of a comparable duration, and are the likely focus of any QE3 program from the Federal Reserve.

The next week is critical for the stock market. If it doesn't pick up soon in response to this latest Fed policy action, the alarm bells may begin to sound that the powerful tool relied upon for so long to juice the markets has finally worn itself out. It should be very interesting to see.

Disclosure: I am long GLD, SLV, K, HNZ, LNT, 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.