Stocks: Navigating The 4 Phases Of QE

by: Eric Parnell, CFA

Make no mistake about it. The forces of monetary stimulus have a hugely distorting effect on the stock market. A look at how the stock market has performed during the various phases of quantitative easing (QE) since the beginning of the financial crisis reveals exactly how much.

Before going any further, it is worthwhile to put the stock market into a historical context. As we all know, the stock market either rises or falls with each trading day. And over the last 80+ years of stock market history, the stock market has risen slightly more than half of the time at 52%. Conversely, it has fallen slightly less than half of the time at 48%. While slightly tilted to the upside, the stock market has represented a fairly even bet on a daily basis over the long-term. This, of course, is not at all what we have seen since the forces of QE have been introduced to the market.

Phase 1: QE On

The first to examine is the phase that has been most prevalent since the crisis struck several years ago. This is the phase when the Fed is fully engaged in monetary stimulus of either literal or effective large scale asset purchases, also known as quantitative easing, to flood the financial system with liquidity. And stocks have traded under the influence of QE on 571 out of the 736 total trading days since the market bottom in early 2009. What is notable is that stocks have traded higher in 339 of these 571 days, while trading lower in only 232 trading sessions. This represents a 59% up to 41% down split, which is an enormous deviation from the long-term historical pattern of 52% to 48%. Thus, the rising stock market since the market bottom is not necessarily a reason for optimism. Instead, it just shows how markets can numb themselves to the pain when they become intoxicated on stimulus.

Phase 2: QE Afterglow

The two past stimulus cycles of QE1 and QE2 came to an end. But just as the skies do not go immediately dark once the sun sets, and just as we do not feel sober the moment we stop drinking alcohol, stocks have not immediately corrected once these past stimulus programs came to an end. After QE1 on March 31, 2010, the market continued in afterglow for 16 trading days. And following QE2 on June 30, 2011, stocks still floated for another 15 trading days. Over this small sample of 31 trading days, stocks rose in an extraordinary 21 sessions while falling in only 10, which represents a 68% to 32% split. Reactions to change are not necessarily immediate, and this appears true for investment markets. In the case of stocks, it seems they enjoy a three week grace period before the sobering reality sets in.

Phase 3: QE Off

On two separate occasions, the Fed pushed the markets out of the nest to see if they could fly without the support of monetary stimulus. And on both occasions, stocks swiftly came crashing back to the ground. In the 736 trading days since the market bottom in March 2009, the Fed has allowed the stock market to stand on its own without stimulus or the promise of impending stimulus on only 60 trading days. And these 60 trading days were absolutely ugly. Overall, stocks only rose in 19 sessions while dropping on 41 trading days. This is a stunning 32% to 68% split over a brief stretch that includes a flash crash as well as two cascading sell offs where the stock market shed roughly -20% in a matter of days. The message here is that the stock market is nowhere near ready to stand on its own, particularly at the current artificially high levels above 1300 on the S&P 500. One wonders where the market would actually settle without the endless support of QE. Perhaps someday we'll actually find out.

Phase 4: QE Tease

The reason we do not know where the market would finally settle without monetary support is because the Fed is lightening fast to step back in with explicit teases of more stimuli the moment any signs of weakness begin to descend on the stock market. When stocks were declining during the summer of 2010 after QE1, the Fed quickly arrived with some preliminary policy actions, which included the reinvestment of MBS proceeds, and promises that more action would be coming soon. The same occurred this past August. With stocks plunging, the Fed swiftly stepped in with its 0% interest rate promise through mid-2013 along with unambiguous hints that more substantive policy help would follow. These QE Tease periods from early July 2010 to late August 2010 as well as early August 2011 to the end of September 2011, both of which leading up to the next explicit "QE On" phase, helped stem the bleeding and stabilize the market. Over the 76 trading days when the Fed was teasing that QE would come soon, stocks gained in 42 sessions and declined in 34 sessions, representing a 55% to 45% split.

With all of this in mind, it is worthwhile to consider stepping in to capitalize as long as the Fed is stimulating. But here is the challenge for stock investors - the impact of each additional round of monetary stimulus is fading both in magnitude and duration. For example, over the last 90 trading days of QE2 from mid February 2011 to the end of June 2011, the market was up in 48 sessions and down in 43. This represented a return to the traditional 52% to 48% split, and stock performance during this stretch became very lumpy. It is worth noting that we are currently approaching a very similar stage with the current Operation Twist (stealth QE3) program, which implies that now is not the prudent time to focus heavily on stocks. Moreover, stock performance during QE3 has been far more inconsistent and lumpy than it was during QE1 and QE2. Both of these factors suggest the market is increasingly fatiguing on the effects of monetary stimulus.

What is worthwhile instead is to focus on selected individual stocks and other asset classes that have shown the ability to perform well not only during the policy induced highs but also during the periods of volatility along the way as well as the severe corrections that follow once the afterglow of stimulus fades. Names that have repeatedly held up well in this regard include McDonald's (NYSE:MCD), HJ Heinz (HNZ), JM Smuckers (NYSE:SJM) and Westar Energy (NYSE:WR). A variety of asset classes outside of stocks have also shown the ability to consistently rise with indifference to what QE phase the market finds itself in at any given point in time. These include U.S. Treasury Inflation Protected Securities (NYSEARCA:TIP), Agency MBS (NYSEARCA:MBB) and Gold (NYSEARCA:GLD).

Bottom Line

The forces of ongoing monetary stimulus have heavily influenced stock market gains. And in the fleeting moments where we have the opportunity to see how the market might actually perform without this monetary crutch, the results are disconcerting to say the least.

Thus, the stock market advance over the last several years has little do to with any underlying economic improvement. Instead, all it demonstrates is how high the stock market can float when it is drunk on liquidity. Unfortunately, it appears that the subsequent hangover once the drinking eventually comes to an end may prove particularly painful. For indulging even more when one is already intoxicated does not make the subsequent hangovers better. Instead, it makes them even worse. This principal would be worthwhile for policy makers to keep in mind when considering any further policy action going forward.

Disclosure: I am long GLD, MCD, HNZ, SJM, WR, TIP, MBB.

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.