An ailing patient eventually stops responding to adrenaline over time.
Such is the growing risk facing monetary policy makers in relation to their ongoing stimulus efforts. At one time, the injection of monetary stimulus had a profound impact on risk assets including stocks. But as time passes and with each subsequent injection, the impact increasingly fades away. Even if monetary stimulus persists with the strategy of supporting capital markets at all cost, we will eventually reach a point where the stock market stops responding altogether.
First, it should be clearly stated that we are essentially operating with QE3. It hasn't been called QE3, but it is effectively QE3. In fact, this policy was put in place back at the beginning of October with the launch of Operation Twist. Officially known as the Fed's Maturity Extension Program, the Fed has committed to purchase $400 billion in par value Treasuries with remaining maturities of 6 to 30 years in exchange for equal par value Treasury securities with remaining maturities of 3 years or less. This program is set to run through the end of June 2012.
While this does not literally represent the unsterilized Large Scale Asset Purchases and balance sheet expansion that characterized QE1 and QE2, it effectively does when you get down to it. This is due to the fact that the short-term Treasury securities being purchased by the banks from the Fed are essentially cash equivalents, particularly now with the Fed's accompanying mandate to keep interest rates locked at 0% until the end of 2014, which is roughly 3 year from today.
Before going any further, the Fed should receive credit for one thing. I have found it bothersome in the past to hear Fed officials suggest that they are engaging in quantitative easing with the objective of keeping borrowing costs low, when these same interest rates surge higher from the moment a QE program was put into place. At least with its latest stimulus program they have figured out a way to inject stimulus while also keeping long-term borrowing costs down. I'm not saying I agree with the latest monetary policy move, but at least they're not contracting their intentions with this latest policy action.
The chart below supports the notion that we're now fully engaged in what amounts to another round of QE. While trailing the total cumulative stock market performance following the launch of QE1, today's stock market is following almost the exact path seen once QE2 was explicitly confirmed to the market in late August 2010.
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Since we're now effectively in another QE phase, it is worthwhile to measure its current impact relative to past stimulus measures. Sure, the stock market is following the same path that we saw during QE2, but at what cost? In other words, is each successive stimulus effort proving equally effective, or is the overall impact of these monetary programs starting to fade.
One way to compare the impact of monetary stimulus on the stock market over each round of stimulus is to evaluate how much in Fed asset purchases is required to generate a +1% rise in the S&P 500 (SPY). This approach helps normalize the data since each Fed stimulus program involved different amounts of asset purchases with QE1 totaling $1.725 trillion, QE2 at $600 billion and OT/QE3 coming in at $400 billion.
It must also be recognized that each of these stimulus programs occurred over different time periods, with QE1 lasting 268 trading days, QE2 running 213 trading days and OT/QE3 currently at 89 trading days and counting. While the overall conclusions are generally the same, the analysis will focus on the results after 89 trading days for each stimulus program to normalize the results even further.
The following are the results:
In the first 89 trading days following the sustained launch of QE1, the Fed carried out roughly $175 billion in asset purchases as measured by the net expansion of their balance sheet during that time. Over this same period from early March 2009 to mid July 2009, the stock market as measured by the S&P 500 rose by +37.86%. This implies that Fed stimulus was generating a one percentage point increase in the stock market for every $4.62 billion in monetary stimulus.
When examining QE2, we see some of the overall impact from stimulus starting to fade. Over the first 89 trading days following first the confirmation then the official launch of QE2, the Fed completed roughly $150 billion in asset purchases and the stock market rose by +21.45%. This implies that the cost associated with generating a one percentage point increase in stocks had risen to $6.99 billion, a 50% increase from the QE1. It should be noted that the asset purchase total here does not include MBS repurchases during this time period, which would push the cost per percentage point even higher.
Now on to the current Operation Twist/QE3 program. The Fed has completed roughly $177 billion in asset purchases so far in exchange for asset sales. Once again, this total does not include MBS purchases. Over this time period, the stock market has risen by +23.02%. This implies a cost per one percentage point increase in the stock market of $7.69 billion, another 10% increase from QE2.
So when comparing these three programs purely on the basis of the amount of Fed stimulus over the same time period, we're seeing an increasing deterioration in the impact of these stimulus programs. But unfortunately for today's stock market, the story does not end there.
First, the positive boost for stocks associated with the current stimulus program may not last. While the QE2 impact on stocks got off to a good start, it ended with a thud. For once the stock market peaked in mid February 2011, it essentially traded sideways for the rest of the program. By the end of QE2 on June 2011 when all $600 billion had been deployed, the cost per percentage point of stock market advance had ballooned to $22.98 billion since the S&P 500 only added just under 5 percentage points over the last five months and $450 billion in additional stimulus. So just because stocks are responding now to stimulus does not mean that this trend is going to continue through the remainder of the program.
Second, and perhaps much more significantly, is factoring in the activities of the European Central Bank (ECB) to the Fed's stimulus efforts. During both QE1 and QE2, the ECB did little if anything to stimulate the markets through balance sheet expansion. If anything, they had periods where they were marginally contracting their balance sheet. The complete opposite is true this time around with the current OT/QE3 program, however. The ECB has already expanded their balance sheet by 900 billion euros over roughly the same time period, which amounts to roughly $1.15 trillion dollars. This represents an enormous asset compliment to the $400 billion in Fed asset purchases.
And when factoring in even a portion of this ECB balance sheet expansion into the equation, we see that the monetary stimulus cost for each percentage point rise in the S&P 500 is vastly more than it had been in the past. For example, being conservative and adding into the mix only the $340 billion net liquidity increase resulting from the ECB's LTRO 1 in December, all of the sudden the market is getting only a +1% increase for every $22.37 billion in stimulus injected into the system. This suddenly represents a +320% increase in required monetary injections over QE2 to achieve the same result. In short, a lot more stimulus is now going into the market, and we're seeing a lot less of an impact from this stimulus at this stage.
The bottom line here is that the impact of Fed stimulus measures appears to be increasingly losing steam. Not only is it providing a diminishing boost, but the duration of its impact also appears to be lessening. And the volume of money printing required to generate further stock market increases is becoming all the more expansive.
Eventually we will reach a juncture where the effectiveness of monetary stimulus in lifting stock prices will eventually run out. And perhaps we are closer to this juncture than the market is aware. Given that monetary stimulus has been such an instrumental driver of asset prices to this point, this highlights the importance of remaining hedged in the current environment. For not only are stocks overbought at current levels with an RSI now above 75 and momentum readings at cyclical peaks, the artificial boost that has lifted them to this point may be starting to fade just as the crisis in Europe appears poised to take a unsettling turn with the situation in Greece continuing to drag out.
Thus, maintaining exposures to asset classes that can both benefit from current Fed policies while at the same time provide protection against a stock market correction is beneficial in the current environment. This includes allocations to safe haven categories such as gold (GLD), silver (SLV) and U.S. Treasury Inflation Protected Securities (TIP). An allocation to Agency MBS (MBB) is also worthwhile given its relative yield advantage over comparable duration U.S. Treasuries along with the fact that they remain the likely focus of the next Fed stimulus program that would likely get underway sometime after Operation Twist draws to a conclusion at the end of June.
Additional protection against the deflationary shock outcome can be established through exposures to Long-Term U.S. Treasuries (TLT) and Long-Term U.S. Treasury STRIPS (EDV). And as for existing stock allocations, emphasizing more defensive names that can continue to participate to the upside but have demonstrated the ability to protect against downside market shocks may also prove beneficial. Representative names under this theme include McDonald's (MCD), Family Dollar (FDO), Bristol-Myers Squibb (BMY), Atmos Energy (ATO) and WGL Holdings (WGL).
It seems that the market is responding less and less to monetary stimulus. But instead of pumping the patient full of additional adrenaline to diminishing effect, perhaps monetary policy makers would be better off to conserve these resources to see how the market might fare on its own. And maybe a little less intervention might lead to a little more confidence in the end. Perhaps we'll find out before its all said and done whether the Fed wants to or not.
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.