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The market is making a decision. After a sharp drop in May 2012, the stock market rebounded significantly, recovering most or all of its losses. But not much has changed: China continues to show economic weakness and a major slowdown, Europe is still experiencing a massive liquidity crisis and has officially entered into recession, the Middle East tensions stemming from political uprisings and the Iran nuclear threat have not subsided, and the U.S. is still flooded with unsustainable debt and plagued by growing economic and political uncertainty. Are things really getting better? Why does the stock market continue to rise when the future outlook remains fairly bleak? Who will win the presidential election, and how will it affect us? Is the worst behind us, or are people ignoring the trouble ahead? And what can and should be done to get the economy going again?

No one really knows the answers to these questions. Even central bankers, policy makers, investment banks, hedge funds, and economists are completely confused. We could muddle along and the economy could drag on with slow growth, but it is more likely that a big directional move is upon us. The U.S. stock market is up over 100% from the 2009 bottom, largely due to central bank intervention and investors' hopes that the recovery is sustainable. But the huge financial, economic, and geopolitical threats are here and must be dealt with now.

It appears that a "shock" event is approaching -- either positive or negative. We will either see a sustained economic recovery, which could result in rapidly rising stock prices as uncertainty fades and investor confidence returns, or we could see a plunge back into recession as the reality of global economic slowdown and financial crises takes hold. We've debated these future possibilities for over three years now; it's time for someone to be right.

All Eyes on the Fed

And it may all be in the hands of the Fed and central banks around the world. Nearly everyone is expecting the Fed to stimulate the economy and boost asset prices with a third round of Quantitative Easing (QE3). Rightfully so, investors and economies have benefited for the past three years as government and central bank stimulus has boosted asset prices and lifted stocks. Stimulus, money-printing, and bond purchases have been the solutions used by the Fed and central banks for supporting the economic recovery and fighting the growing threat of deflation (which generally accompanies recessions and results in falling asset and commodity prices). In other words, the Fed has boosted the market for over three years now in order to support an economic recovery.

But with each stimulus measure or QE being less and less effective and greatly increasing the risk (even according to Fed Chairman, Ben Bernanke), can the Fed and central banks really do more? Will the Fed have to wait for economic conditions to really deteriorate before embarking on a QE3 program? Do the potential benefits outweigh the big potential risks? And can stimulus and QE even stave off the deflationary and recessionary pressures that continue to grow? After four years of stimulating the economy, the jury is still out as to whether the Fed has made the right decisions. Now, with continued pressure to do more and with massive expectations that the Fed will step in again for QE3, we are likely approaching the decisive future direction of stocks and economies worldwide.

Summer "Doldrums"

We just experienced an excruciatingly boring and uneventful summer in the markets. This is many times the case however, as vacations and the off-season lead to decreasing trading volume and the avoidance of big decision-making. There is a reason why the June to August period is referred to by many as the "summer doldrums": people, companies, and governments tend to push things off until September, when school and work are back in session and there are no more excuses for laziness. Now and through year-end is when big events could take place.

The market is full of excuses. It takes time for investors and the world to digest the news and make decisions about the future, but sometimes these decisions can be pushed off for months before anyone has clarity about the situation. Decisions need to be made in order to move forward, but fear and uncertainty can lead to "decision paralysis." In our case, the market has had plenty of "excuses" to just "wait and see." Specifically, the quiet of summer and the major upcoming presidential election have allowed businesses, governments, and investors to push things off, kick the can down the road, and wait for the Fed and central banks to act.

As September begins and the active trading season is upon us, big decisions will be made. The Fed may step in with QE3 at some point, but the timing and the size of the program could have a big impact on its effectiveness.

Possible Fed Actions

1. Fed announces QE3 before November. Many investors and economists are expecting QE3 to be announced soon (Goldman Sachs (NYSE:GS) expected it by June!), and the Fed's decision to embark on QE3 in the next two to three months could send stock markets up as investors rely on the "Bernanke Put" and central bank support to protect them from losses.

Problem: There already is major backlash against QE and stimulus plans from the more conservative politicians. With "Audit the Fed" being backed by a number of influential politicians, including Congressman and ex-presidential-candidate Ron Paul, it doesn't look like Bernanke has much room to act. Not only does Bernanke face major resistance when it comes to QE3, but to do so right before the elections could be highly damaging to his position. Announcing QE3 before elections could be risky or even impossible due to political backlash. At the same time, however, Bernanke might want to announce QE3 now, before the elections, because if Mitt Romney wins Bernanke's power could be severely limited and he could even lose his job.

2. Fed waits for a significant slowdown. Since Bernanke himself admits that additional stimulus and QE measures could pose significant risks that we still can't even predict, the Fed may wait for a significant deterioration of the economy or employment before acting. With the U.S. stock markets at four-year highs, and with growth rates still positive, it is hard for the Fed to argue that significant QE is necessary here. Yes, stimulus could help prevent further economic deterioration or the onset of deflation; but the Fed doesn't want to greatly increase the risks and use its last bullets until absolutely necessary.

Problem: Waiting too long to act could result in ineffective QE3. It is risky to launch a stimulus program when the market is doing well, but if the Fed waits until economic conditions deteriorate it could be a useless effort. If the stock market and economy begin to fall sharply, Fed action may be ineffective in stopping the decline. If momentum builds to the downside, the Fed may be helpless. As technical analysts say, "don't catch a falling knife" -- falling knife referring to falling stocks. If the Fed tries to catch a falling knife by implementing a QE program, it too may get harmed, and at the least will be ineffective.

3. Fed announces QE3 after elections. The Fed could wait until after the elections to announce QE. Such a strategy would allow the economy to breathe a bit and to give the Fed some more information about the true economic and financial conditions. Waiting for after election would also allow for governments, central banks, and markets to push off the decision making once again. Waiting would also prevent interference with the election, which could hurt Obama. This is perhaps the more likely scenario.

Problem: Waiting until after elections could be risky both if Romney wins (conservative Republicans oppose QE) and if the economy deteriorates significantly until then. Announcing QE3 near year-end could also interfere with other financial issues -- if everyone focuses on QE3, they may ignore the huge issues of tax-cuts and the fiscal cliff.

4. Fed doesn't announce QE3. The Fed knows that stimulus and QE is very risky, and would prefer not to use it if not absolutely necessary. That said, the Fed may decide not to introduce QE3 and instead could attempt to boost the economy in other ways. Not announcing QE3 could also signal that the economy is actually better than most people think, and may even be a good sign for the market.

Problem: With most investors worldwide expecting central banks to step up in a big way, a failure to actually launch a QE3 program could trigger massive disappointment. Since many funds, investors, businesses, and banks have strongly relied on the Fed and other central banks to support the markets and the economy, the failure to announce a QE3 program could send the markets into a panic.

Conclusion

While I personally don't think QE3 is worth the risks, and would rather see the market deal with its problems without outside intervention, the Fed has dug itself into a deep hole. After becoming firmly entrenched in a cycle of stimulus and monetary easing, the Fed is left with risky and unfavorable choices -- does it continue its decreasingly effective and potentially highly damaging QE program, or does it decide to limit the risk and attempt to support economic growth in other ways? If it continues QE, markets and investors will be appeased, but perhaps not for long; if the economy doesn't get fully back on track after QE3, recessionary forces will finally gain an upper hand and all of the Fed's attempts will have been nothing more than a delay of the inevitable.

Moreover, the announcement of QE3 could even result in falling markets as investors "sell the news" after they have "bought the rumor" for over a year. The Fed's decision to finally embark on QE3 could trigger a lot of selling pressure. On the other hand, if the Fed decides not to go through with QE3, the market could be severely disappointed with the signal that central banks may not be able to boost the markets anymore after all. Though not deploying QE3 may be smart and prudent by the Fed, and could even signal an improving economy, investors want to hear that the Fed stands behind asset prices and will continue to boost the market. Why should investors stay invested in stocks (NYSEARCA:SPY) or gold (NYSEARCA:GLD) if the giant support by the Fed is removed?

Ben Bernanke has done a good job of strategically timing Fed announcements, and has helped boost markets for three years now. His leadership has been respectable, his attempts at transparency should be admired, and his open-minded outlook regarding possible economic outcomes may help him avoid fatal errors. Has Ben Bernanke "saved the global economy," though? Not necessarily. Not yet. That is yet to be determined.

Source: Can The Fed Save The Economy?