Operation Twist 2 Is Not Enough To Rally Stocks

by: Eric Parnell, CFA

The market has Fed stimulus on the mind once again. Just like a junkie looking for the next fix, investors are increasingly clamoring for the Federal Reserve to stand ready to launch another stimulus program with the economy weakening and the market down -7.5% from its April 2 peak. Never mind that the stock market is still UP +5.6% for the year on the S&P 500 through Thursday's close. Never mind that the last several rounds of stimulus have failed to generate a sustained economic growth recovery. And never mind that the current Fed stimulus program in Operation Twist is still ongoing through the end of June. Investors want more stimulus and they want it now.

The fact that the stock market is so dependent on monetary stimulus is troubling in its own right. To begin with, an investment thesis that hangs its hopes on what a single individual and his supportive committee in Washington DC might do or not do in the coming weeks lacks much of the fundamental and technical rigor that one would typically seek to apply in a sound and sustainable investment analysis. But such are the markets that we live in today. And as I've always said, mine is not to decide on monetary policy but only to respond to the expected impact on investment portfolios.

So what can we reasonably expect from the Fed in the coming weeks? The next Fed Open Market Committee is scheduled for June 19-20. Investors are monitoring three different outcomes.

The first outcome is the Fed suggesting that they will take no policy action at all. As someone who believes the economy and markets need the opportunity to finally clear at this point, I would welcome this outcome. But this is unlikely for the following reasons. First, stepping back from providing more stimuli is simply not the philosophy of the current Fed. Instead, they have shown the propensity to take swift action on any signs of weakness. Also, the U.S. economy is decelerating enough where they will at a minimum feel compelled to reassure the markets that they will take action if necessary. Lastly, the situation in Europe remains on the brink of crisis, and the Fed will need to stand at the ready to respond with support if conditions begin to unravel across the Atlantic.

The second outcome is the Fed making allusions to engaging in another round of balance sheet expansion with QE3. But this is an unlikely outcome for a few key reasons. First, while the U.S. economy is showing signs of decelerating, recent readings are not sufficiently poor to justify such aggressive action. Also, such a bold move would be politically controversial with the Fed already under heavy fire for what some in Congress perceive as past policy missteps, particularly with QE2. Lastly, the Fed most likely does not want to have it perceived as trying to influence the upcoming Presidential election in November. Thus, the Fed is likely to favor a more measured policy prescription than QE3.

The third outcome is the Fed signaling that they will launch Operation Twist 2 in an effort to provide continued support to the economy and markets. This is the most likely outcome for the following reasons. First, it has been a stimulus program that has generally flown below the political radar but still enables the Fed to provide a degree of economic and market support. This is due to the fact that the Fed's balance sheet is not explicitly expanding, although it's composition is still changing dramatically under such a program. Second, although the Fed is running low on short-term Treasuries set to mature in the next three years, they have the flexibility to modify the specific details of the program enough to make it work.

With Operation Twist 2 currently the most likely outcome, the next critical question is the following. Exactly when would the Fed launch such a program? Barring a catastrophic market event over the next two weeks, the Fed is not likely to officially act at its upcoming June 19-20 meeting. This is due to the fact that not enough bad news has happened yet for the economy and markets to justify the Fed taking action. Instead, they need additional signs of economic weakening and a more severe market correction that takes the S&P 500 down into at least the 1140 to 1180 range. Thus, the Fed is unlikely to take any action until at least its next meeting on July 31 and August 1. This implies that the stock market will likely be standing naked for at least a month without Fed stimulus if not longer.

This leads to the final and most important question for the stock market. How should we expect the stock market to respond to Operation Twist 2? Unfortunately for stock investors, the market reaction may be rather disappointing. A closer examination of the current Operation Twist reveals why.

Click to enlarge

The stock market response to Operation Twist has been lackluster at best. The current program was launched at the beginning of October 2011 and will conclude at the end of June 2012. Along the way it appears that the stock market has rallied by nearly +20% even with the recent sell-off since the beginning of April. But such a conclusion ignores an important point, which is that the European Central Bank also carried out its own Long-Term Refinancing Operations first in mid December and again at the end of February. And it was only during this LTRO phase that the stock market entered into a QE like euphoria. Otherwise, stocks have been choppy at best when left with Operation Twist only.

Click to enlarge

A closer look at stock performance under Operation Twist only is even more troubling. Stocks initially responded tremendously when Operation Twist was launched back in October 2011, rallying by nearly +17% over the first 20 trading days. But since that initial burst, stocks have been steadily fading ever since on Operation Twist only. After 123 trading days where Operation Twist was the only stimulus support for the market, stocks are cumulatively up by less than +5%. And this reading was less than +2% as recently as last Friday. And, perhaps most notably, the stock market is actually in a full blown correction under Operation Twist only, having fallen by over -10% in the last 103 trading days after the initial burst at the very start of the program.

Thus, Operation Twist 2, which is the most likely outcome from the Fed, is not likely to be enough by itself to ignite a sustained stock market rally. The market may initially spike higher, but the upside may be short lived. And the launch of any program is not likely to come for a few months down the road.

As a result, I continue to deemphasize stock exposures at this time. During the Thursday morning rally, I exited short-term trades initiated on May 18 in the SPDR S&P MidCap 400 (NYSEARCA:MDY) and Waste Management (NYSE:WM) and continue to hold only highly defensive names such as McDonald's (NYSE:MCD) and Tootsie Roll (NYSE:TR). I am also maintaining positions at least for now in High Yield Corporate Bonds (NYSEARCA:HYG) as a lower beta substitute for direct stock market exposure.

Instead, I continue to emphasize portfolio allocations that are either indifferent or negatively correlated to the stock market. Core positions that have shown the ability to rise regardless of the vagaries in the economy or the stock market include U.S. TIPS (NYSEARCA:TIP) and Agency MBS (NYSEARCA:MBB), the latter of which has particular appeal given that the asset class is the likely focus of any Operation Twist 2 program. I also recently increased allocations to the defensive Municipal Bond (NYSEARCA:MUB) and Build America Bond (NYSEARCA:BAB) segments. In addition, I initiated a new position on Tuesday in the Swiss Franc (NYSEARCA:FXF) that has also been virtually uncorrelated with the stock market, particularly since the Swiss National Bank currency intervention over the past year. As for negatively correlated positions, Long-Term U.S. Treasuries (NYSEARCA:TLT) continues to represent one of the best ways to effectively short the stock market. Lastly, I continue to maintain dedicated positions to both Gold (NYSEARCA:GLD) and Silver (NYSEARCA:SLV) as a hedge against both currency debasement and crisis.

So for those investors longing for the next Fed stimulus program, they may find even when the goods are delivered, the subsequent high for stocks may be most disappointing in the end.

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.

Disclosure: I am long GLD, SLV, MCD, TR, TLT, BAB, MUB, TIP, HYG, MBB, FXF.