The U.S. Federal Reserve is getting out of the asset purchase game. The Fed's QE3 stimulus program is gradually winding down and is projected to draw to a close by November. Given how dependent stocks have been on Fed stimulus in the post crisis period and knowing that the stock market is a predictive arena, it is worthwhile to begin exploring now where the impact is likely to be most heavily felt as the Fed increasingly withdraws daily asset purchase support.
The stock market has exhibited two distinct identities in the post crisis period. The first is the market that relentlessly rises in the face of all obstacles when receiving its daily dose of U.S. Treasury purchases from the Fed. The second is the market that struggles mightily once the steady drip of Fed support provided by daily outright Treasury purchases is removed. Since the beginning of 2013, the U.S. stock market has been basking in the former. But as the Fed continues to remove $10 billion in asset purchases including $5 billion in critically important U.S. Treasury purchases at each FOMC meeting, the environment is gradually and increasingly migrating toward the unpleasant reality of the latter. While stocks may not necessarily drop off a cliff once QE finally draws to a close, they are far less likely to continue levitating higher, particularly with valuations already at historically rich multiples. Even if the economy begins to sustainably pick up steam, and this is a BIG if, a prolonged and gradually accelerating move lower over the course of the next few years may be in store for stocks.
Could the Fed change course and restart daily U.S. Treasury purchases under such a downside scenario? Unless conditions deteriorate both suddenly and particularly badly, I would assign a low probability to the Fed returning to the asset purchase game. Not impossible, but improbable. While the asset purchase program in QE1 was effective in drawing the global economy and its markets back from the brink in 2009 and into 2010, the marginal effectiveness of each subsequent round of stimulus has since diminished toward virtually nil several years later. And one could easily argue that the marginal costs associated with these QE programs for the economy have long ago exceeded the marginal benefits.
In short, QE is no longer working and the Fed almost certainly knows it despite the fact that they would understandably never admit it. Inspired by Ben Bernanke, QE3 was supposed to be the great final blast of stimulus to propel the economy into sustained growth. It did not work. Instead, the Fed became trapped in its QE3 program for months before finally finding an escape route starting last December. But Mr. Bernanke has since moved on, Janet Yellen is now in charge, and it's time to try something new. The fact that Fed tracker Jon Hilsenrath from the Wall Street Journal is out with an article within minutes of any economic or market news that is even remotely negative telling readers that the Fed will be continuing with tapering should serve as a constant reminder that the Fed remains steadfast in staying the course. And once the Fed is out of QE, they are not likely to bring it back any time soon. If it does return someday, the stock market will have likely sustained a great deal of damage in the process.
So what does this all mean for the stock market? And what sectors of the U.S. stock market are likely to be impacted most as the Fed's QE3 stimulus program finally goes away?
The impact from the loss of QE3 on the U.S. stock market cannot be understated. In particular, it is the end of daily U.S. Treasury purchases that will have by far the most profound effect. The following set of charts show the performance of the U.S. stock market both during periods when the Fed is conducting daily outright U.S. Treasury purchases and when they are not.
Put simply, when the Fed is conducting daily outright Treasury purchases as part of a QE stimulus program, the stock market has soared. When they are not conducting such purchases, the stock market has languished. And assuming the Fed does not reengage another Operation Twist program like they did starting in October 2011, the downside drag on U.S. stocks could be even more profound.
Within the U.S. stock market, two sectors more than any others most notably benefited from Fed stimulus.
The first has been the Industrials (NYSEARCA:XLI) sector. Historically, industrials have ranked among the most highly correlated with the S&P 500 Index (NYSEARCA:SPY). But during periods when the Fed is engaged in daily outright Treasury purchases, Industrials have realized a notable and widening spread of outperformance over the broader market.
But during periods when these daily Treasury purchases have been removed, Industrials have shown the propensity to more than give back this relative performance advantage.
One segment within the Industrials sector that has performed particularly well under QE has been the Transports (BATS:IYT).
And unlike the broader industrials sector, they have managed to track relative to the broader market during past non-QE phases. Whether the Transports are able to repeat this the next time around remains to be seen.
Another broad market sector that has particularly benefited from QE has been the Consumer Discretionary (NYSEARCA:XLY) sector. Even more so than Industrials, the Consumer Discretionary sector has departed from its historical high correlation with the broader market and has outperformed by an increasingly widening margin of cumulative return that is now twice that of the S&P 500 Index.
Perhaps just as notable is the fact that the Consumer Discretionary sector has also managed to outperform the broader market at least on a relative basis during non-QE phases. It should be noted, however, that these relative gains took place almost exclusively during Operation Twist. Otherwise, the sector essentially tracked the broader market.
The same cannot be said of the Homebuilder (BATS:ITB) stocks within the Consumer Discretionary sector, however. The economically important Homebuilders were never able to keep pace with the broader market during periods of QE. And they have increasingly languished in trading sideways throughout almost all of QE3.
This relative underperformance to the broader market by Homebuilders has historically not been recovered during periods when the Fed is not engaged in asset purchases. Interestingly, it was only during Operation Twist when we saw Homebuilder stocks meaningfully pick up ground relative to the broader market.
Of course, just because we witnessed these relationships in the past does not mean that they will be repeated in the future. All else is not held equal, and it is possible that forces could present themselves that could lead to an entirely different outcome the next time around. But at a minimum, some of the relative performance divergences that we have seen during QE3 among selected sectors or industries have the potential to fully reverse themselves in a fairly meaningful way once this stimulus is removed, particularly if no new Operation Twist is put in place as expected. And on an absolute basis, the returns outlook for these sectors and industries are unexciting at best. As a result, it will be worthwhile to explore various categories that have either shown resilience during non-QE periods or may already represent good values due to the fact that they have departed from the euphoric, stimulus induced asset price highs long ago. These are topics that I intend to explore in more detail in upcoming articles.
Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.
Disclosure: I am long stocks via the SPLV and XLU as well as selected individual stocks. I also hold a meaningful allocation to cash at the present time. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.