The die has been cast once again. The U.S. Federal Reserve announced on Wednesday that it would extend its latest stimulus program known as Operation Twist through the end of the year. As I've stated in past articles, I supported QE1 but have strongly opposed all Fed stimulus programs since. And the latest move is no exception. But since I was not in attendance at the Marriner Eccles Building for the latest FOMC meeting nor do not expect to be at any time in the future, mine is not to reason why, mine is but to do or deny.
So what can we expect from the stock market now that the Fed has decided to extend its balance sheet neutral Operation Twist program through the end of 2012? The bottom line: volatility, not euphoria.
This pessimistic take on the stock outlook given the extension of Operation Twist may seem wildly misguided at first glance. After all, stock market (SPY) performance since the day Operation Twist was launched at the beginning of October 2011 has been rather impressive, gaining +20% through Wednesday's close.
A closer examination of stock market performance during Operation Twist reveals a decidedly different story, however. To highlight this point, it is worthwhile to break the timeline into four parts.
The first is the period from October 1 to October 28, 2011 when the stock market initially rallied strongly. To give this first stage context, it is worthwhile to examine market performance in the few months leading up to the launch of Operation Twist. During this initial phase totaling 20 trading days in October, the stock market gained +14%. Thus, more than two-thirds of the gains during Operation Twist were achieved in the first four weeks immediately after it began. But this gain largely represented a bounce to recover much of the losses that had occurred in early August 2011. In this context, these initial gains are less exciting.
The second is the period from October 28 to December 20, 2011. This marks the time following the initial Operation Twist bounce through to the day before the European Central Bank (ECB) launched it's balance sheet expanding Long-Term Refinancing Operation (LTRO). The performance of the stock market during this phase was choppy and generally poor. Stocks began plunging sharply through the end of November. They then rallied sharply upon the announcement of a coordinated global central bank liquidity program designed to thaw frozen short-term credit markets for European banks (note that the market began rallying sharply two days before the public announcement of this program, but that is the subject for a different article altogether). But even this rally was fleeting at just eight days before stocks fading again toward the beginning of the ECB's LTRO. In short, the stock market struggled on Operation Twist alone, even when another liquidity injecting program was throw into the mix along the way.
The third is the phase from December 21, 2011 to February 29, 2012. This was the period where the markets had BOTH balance sheet neutral Operation Twist from the Fed AND balance sheet expanding LTRO from the ECB. The chart above tells it all, as this is the stock market euphoria that so many have come to know and love from their central bank stimulus programs. Did we have continued signs of risk and economic deterioration during this time period? Absolutely. Was anything notably different economically during this phase than previous or subsequent phases? Most certainly not. But when the stock market gets high on true stimulus euphoria, nothing else seemingly matters, as it is nearly impossible to even witness the stock market going down on any given trading day.
The fourth is the phase from March 1 through Wednesday, June 20, 2012. This marks the time once the ECB's LTRO ended and Operation Twist was left back on its own. From the moment the ECB and its balance sheet expansion left the building, the stock market choppiness returned. Stocks were able to push higher through March, perhaps on the residual effects following the end of LTRO, but by April the hemorrhaging began. And by the beginning of June, stocks had fallen by -11% from recent peaks. And what has driven the rally in the last few weeks? Largely hope that the Fed would provide added balance sheet expanding stimulus in QE3, as it certainly has not been driven the economic outlook or any sense of resolution in Europe, both of which have been deteriorating further in recent weeks.
This leads us to the bottom line. Operation Twist alone is not enough to send the stock market on a euphoric run higher. To the contrary, stock returns have actually been net negative under Operation Twist only if one excludes the initial and fleeting bounce that occurred in October 2011. And any initial bounce we might have expected from the extension of Operation Twist has likely already occurred given the stock market has already added 80 S&P points in recent weeks. Unless stocks get the added support of a balance sheet expanding stimulus program from the ECB in the near-term, it is very possible that we could see stocks resume their grind lower in the coming months.
So what did the Fed accomplish with the decision to extend Operation Twist?
First, they have greatly reduced the potential for a sharp summertime stock market downdraft similar to what we saw in 2010 and 2011. By extending Operation Twist now, they are providing the same degree of market backstopping through the remainder of the year that has existed to this point. The main exception would be a shock event such as Europe plunging into full-blown crisis. Instead, it is now more likely under this OT extension that the stock market could grind lower for a prolonged period instead of plunging all at once.
Also, the Fed has now set a clear policy path. By extending Operation Twist, this overcomes any potential controversy associated with implementing stimulus leading up to the November Presidential election. This move also clearly defines the likely criteria for the implementation of balance sheet expanding QE3. Unless the stock market craters lower or the situation in Europe begins to chaotically dissolve, the Fed is likely to hold off on implementing QE3.
Lastly, the Fed has essentially left themselves with one final policy bullet in the chamber. I heard on numerous occasions in recent days that "the Fed did not want to disappoint the market". If this was truly a key reason why the Fed was compelled to act on Wednesday by extending stimulus, this is deeply troubling from a policy authority and discipline standpoint for a vast number of reasons. But by acting today, they have proven themselves completely subservient to the stock market. In the process, they have preemptively removed one of the few remaining policy levers they could have otherwise dangled in front of a market that is already far too overly dependent on monetary stimulus.
In the wake of the Fed's decision to extend Operation Twist, portfolios should benefit from focusing on trading opportunities associated with stocks exhibiting the following characteristics: high earnings and financial quality, low price volatility, discounted valuations and attractive dividend yields. Representative examples include Microsoft (MSFT), Wal-Mart (WMT), ExxonMobil (XOM), McDonald's (MCD) and Nike (NKE). Capturing names such as these at technical oversold levels may prove particularly worthwhile in the coming months, particularly if market volatility continues, global economic uncertainty continues to build and hopes rise that QE3 actually gets implemented. And the quality associated with names such as these will help limit the downside under any crisis scenario.
From a broader perspective, the best opportunities continue to reside outside of the stock market, particularly now that the Fed has opted to move forward with just Operation Twist for now. These include bond categories such as Long-Term U.S. Treasuries (TLT), Build American Bonds (BAB) and Agency MBS (MBB). Favoring precious metals such as Gold (GLD) and Silver (SLV) over stocks may also prove beneficial moving forward even though both metals have performed fairly poorly during the balance sheet neutral Operation Twist program.
In the coming days, I will be submitting two follow up articles that will explore the outlook for both bonds and precious metals under the extension of Operation Twist in more detail.
The bottom line for stocks: Unless central bank balance sheets are expanding, stocks are not euphorically levitating. Instead, volatility is likely to continue and stocks may end up grinding painfully lower. And for these reasons, more Operation Twist may prove most disappointing to stock investors in the end. Caveat Emptor.
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.