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All eyes are on the Federal Reserve this week as they convene their latest Open Market Committee meeting on Tuesday and Wednesday to discuss monetary policy. A primary focus of investors is whether the Fed will hint about any future policy action.

Such news is important, as the stock market has proven keenly sensitive to the influences of monetary stimulus since the outbreak of the financial crisis several years ago. But while another round of policy support may help stabilize the stock market at current levels, Fed stimulus alone may no longer be enough to drive stocks to new highs. Moreover, it may now be insufficient to offset the forces of a major downside shock.

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A reflection on the movements of the stock market since October 2011 is informative in this regard. The U.S. stock market as measured by the S&P 500 Index (NYSEARCA:SPY) initially exploded higher at the launch of Operation Twist. Having touched a fresh cycle low at 1075, the stock market suddenly reversed and didn't look back for the entire month. From the second day to the second to last day of October, the stock market advanced roughly +17%. But what is surprising is that since the end of October, the net impact of Operation Twist by itself has actually been fading lower from its peak.

The first sign of breakability associated with Operation Twist came on Halloween, as the market became spooked by the collapse of MF Global. By Thanksgiving, the U.S. stock market had bled nearly -10% and was only +5% above the early October lows. The market response to the MF Global bankruptcy was notable, for stocks prior that point had shown the resilience to continue rising during periods of Fed stimulus regardless of the risk. Such was not the case in November 2011.

Stocks thrashed back and forth into December until the week before Christmas. It was at this point on December 21 that the European Central Bank executed the first of its two planned Long-Term Refinancing Operations (LTRO) to support the at risk banking system across the continent.

It was upon the launch of LTRO that the stock market propelled itself into another euphoric melt up phase. This continued until the second planned LTRO on February 29. Along the way, the stock market advanced +14% in a virtually uninterrupted rally that included stocks rising on nearly 70% of trading days over this time period. This is well above the historical average of 52% and is exceptionally rare to occur over any sustained period of market history.

But once the second LTRO was completed at the end of February, the stock market began to sputter once again. Stocks managed to push higher during March, but one might argue that this strength was driven by the residual effects of LTRO 2. But by the time April arrived, the stock stalled and has been struggling over the last few weeks.

Such market behavior has the following implications. While Operation Twist can help stabilize stock prices, it may require the support of other stimulus programs to cause the market to enter another melt up phase. Otherwise, the stock market is prone to periods of weakness during Operation Twist as fundamental forces and downside shocks have an actual impact on price behavior. When extracting the LTRO phase out of the recent rally, we see that the price performance of the stock market has been generally unexciting since the initial pop.

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This perspective is particularly useful as we look ahead to potential policy action by the Fed in the coming months.

If the Fed steps aside and provides no additional policy support, it is likely that the stock market will go down just as it has in the past during these phases.

If the Fed opts to launch a full-blown QE3 that includes direct and explicit balance sheet expansion, this would have the potential to push stocks meaningfully higher in the coming months. But then again, much of the marginal impact of QE may now already be realized. Furthermore, launching QE3 is a messy path for the Fed.

Not only is the Fed facing increased political scrutiny about their policy actions and the perception by some that more recent policy responses have been less than effective in promoting sustainable long-term economic growth, but they also face the dilemma that rising energy prices accompany rising stock prices with most any QE program. If oil prices are skyrocketing but the economy remains sluggish, this starts to raise stagflation concerns. This is an outcome the Fed would likely want to avoid, particularly in the midst of a presidential election season.

The third possibility is that the Fed decides to launch an Operation Twist 2. And if they decide that they would like to be more discreet with this move to avoid political pressure, they may look to initiate such a program with the passing mention of "Sterilization", which is essentially code for Operation Twist 2. Such an approach would likely be far less controversial, but also potentially a bit more muted in its impact on the markets.

So what is the most likely outcome looking ahead in the coming months? Operation Twist is scheduled to end in June, so no new program is likely to be launched until then. And although economic data has been steadily weakening in recent months, it is still sufficiently strong that it makes it more difficult for the Fed to justify taking any preemptive policy actions. As a result, the most likely outcome is that we see some sort of repeat of the events experienced during the summers of 2010 and 2011.

The Fed will likely need to allow markets to stand on their own for a period. And if the markets collapse as they did the last two summers, the Fed will have far greater justification to intervene with additional stimulus. And this would most likely come in the form of Operation Twist 2, as the ability for the Fed to launch a full on QE may be too limited, particularly with a major election around the corner.

What does this imply for markets in the coming months? If history is any guide and barring any unexpected shocks either to the upside or downside, the most likely outcome would be a stock market that chops back and forth through the end of June and into early July. But once Fed stimulus is fully removed, stocks may quickly descend into a sustained downside correction, as potentially insufficient buying demand without policy support would be unable to offset increased selling pressure.

And this downside would likely be stemmed eventually by the launch of Sterilization / Operation Twist 2, which would likely provide an initial bounce for stocks before returning back to the sideways chopping pattern for much of the remainder of the year. Once again, this scenario assumes no major upside or downside shocks along the way. What about 2013? This, of course, is a topic for another day with the fiscal cliff lurking with the turn of the calendar.

Such a backdrop implies two priorities from a portfolio management perspective. The first is to remain hedged and to keep stock allocations in proportion to other asset classes in an overall portfolio framework. While the baseline outlook for stocks is unexciting in the coming months, the potential for stimulus driven upside remains. An emphasis on more defensive stocks that have trailed the recent rally to this point is also prudent. Representative names include McDonald's (NYSE:MCD), Tootsie Roll (NYSE:TR) and WGL Holdings (NYSE:WGL) along with the Utilities (NYSEARCA:XLU) sector in general.

The second is to be nimble. As the stock market potentially chops back and forth in the coming months, particularly attractive short-term entry points may present themselves along the way. Thus, holding a cash position that is ready for deployment to capture such opportunities has appeal in the current environment.

Lastly, the more attractive opportunities continue to exist outside of the stock market. This includes precious metals such as gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) that have trailed during the recent rally. Allocations to bond segments is also appealing such as municipal bonds (NYSEARCA:MUB), which is priced at attractive levels following a recent pullback, and Agency MBS (NYSEARCA:MBB), which is likely to be the primary focus of any new stimulus program. And positions such as Long-Term U.S. Treasuries (NYSEARCA:TLT), U.S. TIPS (NYSEARCA:TIP) and the Japanese yen (NYSEARCA:FXY) all have appeal from a stock market hedging standpoint.

We should learn more about the Fed's intentions in the coming days. And given its importance to the stock market in recent years, their words will merit close attention as we move forward toward the end of Operation Twist in June. It should be interesting to see.

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.

Source: Stocks Cannot Levitate On Twist Alone