Finally Big Ben dropped the much awaited third round of Quantitative Easing, hitting the markets on September 13. The investment community got what it was looking for, but will it be able to lift the stock market even more?
To try to answer, let's see some details of the plan and compare it to what happened in the previous two occasions:
Quantitative Easing 1.0 (QE1): announced on 11/25/2008 and active until 03/18/2009, when the Fed upped the ante and proceeded with additional measures. In this first round of monetary stimulus, the Fed purchased $500 billion in mortgage-backed securities and up to $100 billion in debt obligations of Fannie Mae, Freddie Mac, Ginnie Mae and Federal Home Loan Banks.
Quantitative Easing 1.1 (QE 1.1): announced on 03/18/2009 and active until 03/31/2010. The Fed expanded the mortgage buying program and purchased $750 billion in MBS, up to $300 billion of Treasury securities and an additional $100 billion of Fannie and Freddie debt.
Quantitative Easing 2.0 (QE2): announced on 11/03/2010 and active until 06/30/2011. Here the Fed bought $600 billion in long-term Treasuries and reinvested $250 billion in Treasuries from the previous MBS plan.
Quantitative Easing 3.0 (QE3): announced on 09/13/2012, involves the purchase of mortgage-backed securities at a pace of $40 billion per month until further improvements in the labor market.
Here is a quick snapshot of the market reaction around the QE periods:
The first stimulus measure were very effective in boosting the market sentiment and had been followed by overall sustained rallies (in the following graph the performance of the S&P500 index 1,2,3,6,and 12 months after the beginning of the program, and for the whole period):
So what can we expect from this brand new monetary gift?
Unfortunately, I fear it will be far less effective, given the different environment we are facing now. Despite some clear similarities (subpar GDP growth and comparable market valuations with estimated P/E around 13x), a few instances suggest that markets might behave differently this time. In particular we refer to (1) the potential exogenous shocks coming from the Euro area and the slowing emerging market economies, over which a domestic measure as QE has less of an impact (unlike in the aftermath of domestic crisis as after Lehman, AIG, subprime bubble, etc.) and (2) the market behavior in the pre-easing announcement.
Referring to the latter point, QE 1.0, QE 1.1 and QE 2.0 were preceded by impressive market turmoil in the previous 6 and 12 months, while in this case we come from a rather steady and rising performance. The next graph is an extension of the previous one and includes the market movements in the 6 and 12 months before the stimulus announcement:
As you can see, the lower the starting point, the higher the final market rally. This does not bode well for today, given the +24% performance of the S&P500 since March '12. Moreover, another reason for concern is the record level of the profitability of S&P500 companies whose margin expansion is rather unrealistic, depriving the market of another potential lift:
So, despite recognizing the positive catalyst that QE3 represents, we suggest a more cautious approach. Any stimulus is market-friendly per se (as long as it does not create hyperinflation or excessive moral hazard) but a robust positive performance can not be sustained without solid fundamentals, healthy valuations and a decent solution to the anemic global growth. That's why investors should be wary of this apparent low volatility environment and take care when embarking in full-scale cyclical trades. It might be profitable to capture the short-term increase in investor confidence by buying cyclical names or small caps, but mid-term we prefer to buy some protection. Volatility is very cheap at the moment, thanks to the recent rally, and so protecting the portfolio comes at a low price. A reasonable investment is an October Put (at a strike of 1400, 4.4% out of the money, costs only 3.1 points) or an ETF on the VIX, as the iPath S&P 500 VIX short term futures (VXX) which profits with spikes in volatility, usually associated with market reversals.