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In layman's terms, Quantitative Easing (QE) is basically just printing more money, increasing the excess reserves of the banking system. QE is based off of the Reflexivity Theory, which refers to the circular relationships between cause and effect, "If this, then that." When applied to the stock market, the idea behind the concept is that QE puts additional liquidity into the markets so that the value of paper currencies are devalued, which would cause the value of stock prices to get an artificial boost. Consequently, by shooting the stock market with steroids, Americans will feel richer, causing them to spend more money, and thus, lifting up the economy.

The problem with this is that Ben Bernanke, the Chairman of the Federal Reserve, still believes the out-dated notion that the stock market is a discounting mechanism to the economy, meaning when the markets are in bull mode, the overall economy will soon follow. Bernanke does not realize that in the current environment, where there is so much uncertainty that headlines can move the Dow up or down 200 points every day, the number of retail and middle-America investors has significantly diminished, as they sit in cash on the sidelines. The overwhelmingly majority of stock market investors today are large financial institutions, hedge funds, and high net-worth individuals.

After two rounds of QE in the last few years, totaling almost $2 trillion, it has become crystal clear that while QE causes the Reflexivity Theory to take place, it is working in the opposite direction the government's central banking system says it does.

Without question, QE initiates the "cause" by triggering a significant rally in the stock market (via a de-valuing of the dollar), but the effect that follows is just a significant increase in the gap between the rich and the poor. In my opinion, QE is the number one reason this "recovery" has increased the gap between the rich and the poor more than any other recovery in history. As I mentioned above, the Federal Reserve is completely blind to the fact that in the current environment, an overwhelmingly majority of the money invested in the stock market belongs to institutions or funds that are made up of high net worth individuals. And to make matters worse, while the traditional retail investor sits on the sidelines in fear of being in "risky assets," QE is causing their cash to depreciate in value.

The Federal Reserve is holding its next meeting from July 31 to Aug. 1, and has given many indications or hints that a third round of QE could be on the way.

With everything that happens in Washington these days being politicized, here's what I think about the chances of QE3 being announced at the August meeting:

Factors Fed Chair, Ben Bernanke is taking into consideration:

  1. Mitt Romney has stated that if elected president, he will not renew Bernanke's term as Federal Reserve chairman in January 2014. Meanwhile, Obama is a great defender of Bernanke, who was originally appointed by George Bush, then re-appointed in 2010 by Obama, despite heavy pressure from his party.
  2. Historically speaking, the stock market has had a meaningful influence on election results. The incumbent administration usually wins re-election if stocks are rallying during election time.
  3. All macroeconomic statistics are showing that the economy is significantly slowing down, and could be heading back into a new recession. Job reports for all three months of Q2 were so weak they didn't even keep up with normal population growth, and the GDP stats make this "recovery" the worst in history as growth is close to becoming completely absent.
  4. In Bernanke's testimony to congress last week, several members expressed their want for more QE in light of the slowing economy. New York Senator, Democrat Chuck Schumer, made headlines by stating that the Fed is the "only game in town," and telling Bernanke to "Get to work."

Based off these factors, why Bernanke will announce QE3 at the August meeting, and why it is being politically backed …

  1. Despite claiming that he will likely retire after this term is up, Bernanke is an academic type who feels he plays a significant role in getting the economy to have a sustained recovery, and wants to be around when that finally happens. Bernanke knows that if he wants any chance of being re-appointed, it will have to be from Pres. Obama, so he must prop up stocks from now until the election.
  2. Despite the majority of current stock market investors being institutions and funds, it is still the best and easiest way to disguise the poor recovery. With President Obama being the first president in history to mention the stock market's successes in a State of the Union address combined with his March, 2009 call to "buy stocks now," two weeks before the Fed announced the expansion of their first round of QE, it makes it quite clear that Bernanke and Obama are in cahoots.
  3. If he's going to initiate QE3, he can't wait until the Sept. 12-13 meeting. Markets usually take 1-2 months to react to QE, which means that if he initiates QE3 in September, a large portion of its positive effect on stocks won't occur until after the election.
  4. Announcing QE3 in August will help President Obama get much needed campaign contributions from Wall Street, a group who gave him more money in 2008 than any other candidate in history, but have completely switched sides to Mitt Romney this time around as Obama continues to take an anti-business rhetoric across America.

Reasons why Bernanke won't initiate QE3 …

  1. Because QE is based off the Reflexivity Theory, there are several unintended effects (besides the widening gap between the rich and poor). The direct cause of QE is to increase liquidity in order to devalue currencies, which in effect, causes all other asset classes to rise (equities being the intended one). However, because all non-currency asset classes rise, this also causes commodity prices, such as wheat, corn, grain, cotton, gold, and oil, to rise as well. The effect of this is that gas prices, the cost of your groceries, and the cost of clothing apparel will all increase, which is a big negative for an already fragile economy.
  2. Republican politicians are huge opponents of the QE concept, and so far in the campaign process, this issue has gone unnoticed. After two successive failed rounds, initiating a third round could backfire for Bernanke and the president by bringing this issue to the spotlight and having more pundits going thru what the real effects and consequences of this program are.

Prediction:

I feel that without question there will be a third round of QE before the November election, most likely at the August meetings next week, but if not, possibly still at the meetings in September. However, contrary to QE1 and QE2, where the retail investor was hung out to dry by staying in cash, this time I feel the market's euphoria will not be sustained due to the overhanging fear that President Obama will win re-election and get his tax reform passed to double and triple the tax rate on capital gains and dividends.

Reason:

This overhang of tax unclarity on the market is and will prevent investors from putting money to work. Investors in America see raising capital gains taxes to the extent Obama is pushing for as something that completely deteriorates the backbone of the reason you invest in the first place, which is risk vs. reward. There has to be incentive for Americans to take a risk and invest. Cutting your potential reward by 15% diminishes that incentive. Capital gains tax is the wall between an idea and an invention, and you want that wall as low as possible to encourage Americans to take risks.

There is nothing investors hate more than capital gains tax. In order for someone to invest, they had to have money to put to work. They attained that money by either earning it as part of their salary or inheriting it, both of which are forms of income that are already taxed at 35% at the top bracket. They then take their leftover cash to invest, so any additional taxes from this point forward is a double-tax.

Another thing that investors fear regarding the current tax unclarity is the concept President Obama is pushing of having multiple tax brackets for capital gains. In the past, everyone paid the same flat rate for capital gains' taxes, but now, Obama is proposing those who are more successful investors pay a higher rate. In a capitalistic society, the economy is not a zero-sum game. When person A makes a million dollars, person B doesn't have to lose it, the market produces it … So investors don't understand why person A has to give more of their winnings back to person B through a higher tax rate.

In conclusion, with the election so close, and the looming anti-capitalism rhetoric inhibiting the risk/reward factor, QE3 will not have the same propping up effect on stocks as QE1 and QE2 did, and is why I am not recommending to anyone to jump into equities on any announcement.

Source: The Effect Of Politics And Capital Gains Taxes On More Quantitative Easing