QE3: The Good, The Bad And How To Profit From It

by: Paul Nathan

Well, we can now see the cards the Fed's been holding close to the vest: open ended quantitative easing. The Fed will increase its balance sheet about 40 billion dollars per month for the foreseeable future. What does it mean?

Let's do what few others have done. Let's define our terms. QE1 was the Feds way of supplying 1.65 trillion dollars to the banking system to replace capital lost through the fraudulent Mortgage Backed Securities declared triple A by rating agencies, but which were in fact, junk. The Fed injection prevented runs on the banks and a collapse of the financial system.

QE2 was an injection of 600 billion dollars of liquidity to fight deflation and recession which was threatening to take the U.S. into a deflationary recession like the one that has plagued Japan for the last 30 years.

The so-called QE3 is an ongoing increase in the money supply. Considering that we have not seen the Fed's balance sheet increase in over a year, this is essentially a return to normal Fed open market operations. The one thing that has changed however, is that the Fed will, at least initially, only buy bonds in the mortgage market. This is a good thing since it takes away the perception that the Fed is enabling Congress and the Administration to finance its deficits with the Fed's help. This can no longer be claimed, even though it was never true in the first place, at least not to any meaningful monetary or fiscal degree.

Gold shot up on expectations that real inflation is now coming. But we've heard this before, and with QE3 the Fed is simply doing what it has been doing for 100 years -- increasing the money supply. True, the amount is high by historic standards, but we have just come off a recessionary/deflationary scare. Remember, just two months ago people were worried about a new recession, and many were selling their stocks hand over fist preparing for a major sell-off.

To combat this new de-leveraging threat, to offset the de-leveraging yet to come, and to end any lingering deflationary expectations, the Fed has taken an aggressive monetary accommodation stance. I agree with this. It will be anti-deflationary and promote stability to a large extent. Just leveling out the money supply in a predictable way will be stabilizing. The increase in money will likely increase inflation rates and create some distortions in the economy, but under the circumstances I believe it is the best the Fed can do, as long as they abide by their inflation target of 2% per year.

Take a look at the following chart of money supply increases and decreases by percent.

(Click to enlarge)

Beginning next month, this chart should begin to level out. That's a lot better scenario than the erratic up and down chart that accompanied crisis and confusion over the last four years and I believe we are finally back on track to a more normal monetary policy.

I find some irony in what the populace perceives as QE1, 2 & 3. QE1 should have never been titled that. It's the wrong term for a Fed rescue of the banking system. QE1 simply added capital to the banking system to ensure solvency. QE2 naturally sounds like an extension of QE1 -- but it wasn't. It was a reaction to a deflationary/recessionary trend developing that if left to its own devices could have affected this nation negatively for decades. And now QE3 is really just a resumption of a steady increase in money supply in a transparent, and open-ended way. It's simply a policy which allows the Fed to increase or decrease the amount of money based on financial conditions and a targeted rate of inflation. In other words, we are really just back at square one: QE3 means QE.

Now that we are all on the same page about what QE really means, we can determine whether an aggressive monetary expansion will increase inflationary expectations and inflation itself. Most would agree that it should. It should also goose the economy a tad and lead to more predictability of monetary policy in the future for individuals and institutions to plan around. We are back to the kind of monetary policy we are most used to from past decades and will be able to clearly see whether the Fed is progressively inflating or not. I think that determination will be made by using Milton Freidman's old definition of whether "too much money is chasing too few goods." Now it will be easier to determine whether fears being voiced over inflation are justified, and if so they will be relatively easy to address since the Fed can contract the money supply as fast as it increases it. That's what the Fed is there for after all. Its mandate is to promote price stability.

What Fed policy cannot do however is create prosperity or lower unemployment. What I hope and expect to see for the remainder of Mr. Bernanke's term is a steady increase in money supply within the context of price stability. I would not be surprised however to see inflation spike temporarily as it did the last time the Fed injected funds.

This spike, if it comes, will be where the vast amount of money will be made in resource stocks. I intend to grab it quickly and get out. I think the window of opportunity will be narrow.

That's why I've placed stops on my trading vehicles just below recent lows. The following three trading stocks, all with stops under them, represent half of my portfolio: Pan American Silver (PAAS), Coeur d'Alene Mines Corporation (CDE), and Market Vectors Junior Gold Miners ETF GDXJ. Since May, when I went "all in" and took a leveraged position in resource stocks, my trading portfolio is up well over 50%. Locking in profits on this commodity stock spike seems reasonable. If I should be stopped out I can always choose to re-enter, but in a less volatile market. This is, after all, what the trading side of portfolio is for.

However my core portfolio will remain untouched and is made up of exploration companies such as Rubicon Minerals Corporation (RBY), Aurizon Mines Ltd. (AZK) and McEwen Mining Inc. (MUX). These companies have excellent long-term potential and are still down substantially from their past highs. I expect gold to hold at these higher levels, making future profits in most gold and silver companies more attainable. As long as GLD and SLV remain well supported, resource stocks in general should continue much higher in the future. For more see Resource Stocks Ready Rumble.

Disclosure: I am long AZK, MUX, CDE, PAAS, GDXJ, RBY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.