Why QE3 Would Be Bad (And How To Profit From It)

| About: SPDR S&P (SPY)

The relatively disappointing jobs report has spurred an uptick in market chatter about the possibility of QE3. Many investors are hoping that Bernanke will give hints about Fed actions prior to the actual FOMC meeting on July 31-August 1. (Bernanke is testifying before Congress on the 17th.) As Seeking Alpha contributor Chris Ciovacco put it, the Fed has economic and political cover to launch QE3.

But is this something we want?

QE3: Not Gonna Help

The first and most important point to analyze is what QE3 would actually do. Purchasing more T-bonds (or MBS securities) would essentially amount to an effort to lower borrowing costs. As the logic goes, lower borrowing costs will stimulate more borrowing which will increase economic growth... blah blah blah. The theory isn't borne out by the facts.

David Einhorn makes this point most eloquently in his awesome (and fairly sarcastic) op-ed titled The Fed's Jelly Donut Policy.

My point is that you can have too much of a good thing and overdoses are destructive. Chairman Bernanke is presently force-feeding us what seems like the 36th Jelly Donut of easy money and wondering why it isn't giving us energy or making us feel better.

Einhorn's primary argument is that while "easy money" [QE1 and ZIRP] was a quick fix after the financial crisis, continuation of the policy isn't doing much to stimulate additional economic activity. (In fact, as I analyzed in So Much For Risk Off, ZIRP is actually driving banks to take on riskier assets - is that really what we want to promote?)

The point is that after a certain point, lowering borrowing costs a little bit isn't going to be enough to compensate for other problems in the economic backdrop. Think of it this way. Restaurants generally sell soft drinks in the $1-$2 dollar range, at least where I live. Some people choose to just drink water instead of the Coke, to save the $2 on the meal.

But now, let's imagine that to stimulate drink purchases, the restaurant has lowered the cost of the Coke to a dime. Yet the restaurant still finds that a lot of customers aren't buying a Coke. Should they continue trying to lower the price of a Coke to 8 cents, 7 cents, 5 cents - to get those customers?

No. There are very few people who would deem a dime "too expensive" to justify the purchase of a Coke. If people aren't buying soft drinks for a dime, they must have other reasons than cost for not getting a Coke with their meal. Perhaps they're strange aliens who don't like Coke. Or more likely, perhaps a certain percentage of the restaurant's clientele is on a diet, and you just can't convince them to purchase a Coke, no matter how low you make the price.

This is exactly what's happening with QE3, ZIRP, and essentially everything else the Fed is doing to lower borrowing costs. Borrowing costs are already so low that any "customers" who were avoiding borrowing because of cost have already had the opportunity to buy in. The remaining customers choose not to borrow for reasons OTHER than cost - so further cost reductions won't encourage them to borrow. As Einhorn puts it:

What he (Bernanke) cannot seem to acknowledge is that it's been three years of ZIRP, yet credit-worthy borrowers still are not looking for loans.

Interest rates are only one consideration when looking to invest. If it makes sense to build a factory in a 2% ten-year note environment, it probably still makes sense to build it with long rates at 4%. Long duration investments of that nature have so many other risks that, once rates are low enough, further reductions in the marginal cost of money no longer make much difference.

The corollary is that if it doesn't make sense at 2%, it isn't going to make sense at 1% or even at zero, because there must be some other reason not to build. The cost of money has long since passed the point where it is a constraint on otherwise sensible economic behavior in the real economy. Incrementally lower rates no longer trigger large refinancing, let alone construction booms, in the mortgage and housing markets.

QE3: Bad for Investors In The Short Term

As Seeking Alpha contributor Eric Parnell has analyzed in detail, QE and other loose monetary policy actions cause the markets to go up despite fundamental weakness still remaining. And this is bad.

I'm completely bullish on the long-term future for the US stock market (and economy), as I laid out in Hook 'em Horns. But that doesn't mean that I'm looking at the world through rose colored glasses like little Pollyanna. I know that in the short term, factors like the fiscal cliff and Europe and the Affordable Care Act will continue to put downward pressure on the U.S. stock market. (The ACA discourages small business growth by penalizing small businesses that expand beyond 49 employees, which in turn reduces small business spending that could benefit retailers, wholesalers, and other publicly traded companies.)

Despite very strong earnings and record levels of corporate efficiency, the US stock market is fairly inexpensive right now, due to uncertainty about the factors I mentioned above (and many others). This is a great thing for investors. Why? It provides buying opportunities. Down markets are a great time to accumulate additional shares. As Tim McAleenan puts it in his article titled "Why Dividend Investors can Ignore Stock Prices,"

Let's say the stock price goes down. This is great news for the investor. (...) when the $198 quarterly dividend check comes in, the $50 share price will only buy you 3.96 new shares to immediately generate $10.45 in annual income. But if you can reinvest at $40 per share, that $198 quarterly check would buy 4.95 new shares that would immediately generate $13.07 in immediate income. Anytime you're buying something - be it with a fresh cash investment or a dividend reinvestment - you will always acquire more ownership (and thus claims on future dividends and retained earnings) as the price goes down.

Long-term investors, especially those following a dividend growth strategy, will thus be hurt by QE3. Why? Well, if the economic fundamentals (Europe et al) don't change, then there's no reason for the stock market to start trading at a higher valuation multiple. Raising the market to higher multiples when it's under pressure from such factors is the equivalent of giving an exhausted worker an adrenaline shot - they'll get a boost in the short term, but unless they actually get some rest (their fundamentals change), they're still going to return to their state of exhaustion when the adrenaline wears off.

Current market valuations offer a great buying opportunity, and artificially increasing valuation isn't in anyone's best interests.

QE3 Longer-Term: Political Costs

The other problem with the QE3 adrenaline shot is that it masks the longer term issues that we're facing. Again, while I'm cautiously optimistic that these problems will be resolved, it's important to remember that a "Do-Nothing Congress" poses great danger. If we as a country become distracted by a good market, we'll put less pressure on our leaders to actually solve the problems. But as with the adrenaline shot, once the QE wears off and we're forced to face the actual problems, all we've managed to do is delay real progress on issues like the fiscal cliff and unemployment.

It's also not at all inconsequential that an artificial QE prop-up of the market would favor reelection of incumbents. Economic data over the past few years, while showing positive signs, has undeniably been underwhelming. A good-but-artificial showing from the stock market would distract the general public from the actual problems that we face.

In this way, a short-term rally in the stock market would actually harm investors as political problems get pushed under the rug. The short-term rally will fade quickly, but the consequences propagated by the political problems will last a very long time.

Conclusion: Be Ready To Act On QE3

I'm generally a long-term investor rather than a trader. However, just because I invest with a long time horizon doesn't mean I can't be smart about when I invest in what. As David Crosetti laid out in his article Can A Dividend Growth Investor Be A Trader, keeping an eye on relative valuations is important. Just as it might be a good idea to sell one blue-chip when it becomes a little overvalued, so you can use the cash proceeds to buy a more undervalued blue-chip, it's a good idea to occasionally rotate your holdings.

If QE3 is announced but not followed up by any actual economic progress, here's what I'd do: I'd ride the rally, but start looking for ways to preserve rallied capital towards the end of QE3 - because the S&P 500, Dow Jones (NYSEARCA:DIA), and Nasdaq (NASDAQ:QQQ) would inevitably fall. As I've discussed (and see the linked article from Eric Parnell for more analysis), a "collapse" at the end of a QE rally is extremely likely, historically speaking. So while I definitely want to get in on the rally, I'm not so enthused about the collapse.

While profit-taking and hold cash-or-equivalents is certainly an option, it's not one that I like very much. Why? Well, with interest rates the way they are due to ZIRP, you're getting essentially no yield - and if you timed the market wrong and it continues to go up, you're missing out on the rally. One of my favored strategies would be to instead move some equity holdings to high-yield bonds, which provide solid returns but less volatility than equities. This is evidenced by a comparison of the performance of junk bonds (NYSEARCA:JNK) and the S&P 500 in the recent selloff.

As you can see, while junk bonds sold off, they sold off significantly less than equities as represented by the SPY. Additionally, the junk bonds yielded 1-2% in coupon payments over the holding period, vs a dividend yield of about 0.5% for the SPY. At any point during the pullback, you could choose to sell the junk bonds and re-enter the equity market. Sure, you'd lose a little money on the junk bonds - but you lost less money than you would have by staying in the market, and collected more in current income. Thus, you still come out ahead.

I may do something like this in the event of QE3. I'd go into equities at the beginning to catch the rally, but start scaling equity holdings back into high-yield bonds and/or cash/short-term investments as QE reached its conclusion. My overall portfolio composition would only shift 10-12% at most, but it would still give me some shelter from the end-of-QE3 collapse - and at the same time, allow me to keep some of the QE rally gains.

While I am by no means hoping for QE3, as I've outlined above, I do think it is important for traders and long-term investors alike to consider how they will respond to potential market-changing events. The junk bond strategy is just one of many - I'd love to hear other potential strategies in the comments section.

Disclaimer: I am an individual investor, not a licensed investment advisor or broker dealer. Investors are cautioned to perform their own due diligence. All information contained within this report is presented as-is and has been derived from public sources & management. Always contact a financial professional before making any major financial decisions. All investments have an inherent degree of risk. The future is uncertain, and actual results may be materially different from those expected. Past performance is no guarantee of future results. All views expressed herein are my own, and cannot be interpreted as the views of my employer(s) or any organizations I am affiliated with. Presentation of information does not necessarily constitute a recommendation to buy or sell. Never make any investment without conducting your own research and reading multiple points of view.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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