Will QE Dreams Turn To Nightmares?

| About: SPDR S&P (SPY)
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It can be argued that the stock market hasn't really traded on authentic fundamentals since 2009, and proponents to that argument could point to the past two weeks for firm evidence of that.

Like a game of high-stakes poker, the stock market is calling Ben Bernanke's bluff, betting that the Fed Chairman folds his cards and goes ahead with another round of quantitative easing. As many will recall, back on June 7, during a testimony in front of Congress, Mr. Bernanke put the onus on Congress to help the economy out of its rut and did not offer any hint of a stimulus program.

Since, then, however, we have witnessed a global effort to stave off a worldwide recession, with China cutting rates, the Bank of England announcing a 100 billion pound support program, the ECB providing a 100 billion euro bailout package to Spain, and the Bank of Japan also saying it stands at the ready to provide more liquidity. Many are now expecting the U.S. to follow suit when the FOMC begins a two day meeting on June 19, in which the Fed will release its latest policy statement, economic projections, and a press conference with the Chairman on June 20. It is during this press conference that many are expecting a "tell" that the Fed will implement some form of easing, either in the form of a full-out QE3 program, or a continuation of Operation Twist.

Despite a bevy of poor economic data, downward revisions to corporate guidance, and skyrocketing rates on Spanish and Italian debt, the stock market has nonetheless marched higher in June. The SPDR S&P 500 ETF (NYSE: SPY) is up about 5% in June, and the catalyst almost solely responsible is the expectation for more monetary stimulus from the Fed. But, has the market rallied itself out of contention for an immediate announcement of QE? Keep in mind that one of the primary purposes of QE is to increase the "wealth effect" by steering investors towards risk assets such as stocks, by driving rates so low that interest paying debt instruments look very unattractive. Although down a modest amount from its 2012 highs, the stock market really isn't in need of more juice at this point, raising the question of whether Mr. Bernanke will see the need to push through a program right now.

Let's rewind a bit and take a look at how the stock market was performing prior to the announcement of QE2 and Operation Twist. Chairman Bernanke hinted at QE2 in his speech at Jackson Hole in late August of 2010. From April 2010-August 2010, the S&P shed about 15%. Operation Twist began in late September of 2011 and the market had dropped about 17% from July to mid August before that announcement. Again, today, the broader market is actually up 5% over the past month.

Another interesting point to consider is that the SPDR Gold Shares ETF (NYSE: GLD) is basically flat so far this month. While the stock market is suggesting that another round of easing is all but a certainty, the gold market isn't quite as confident. As many are aware of by now, gold prices would shoot higher on the announcement of more easing, as this devalues the dollar, pushing precious metal and commodity prices higher.

With that said, I certainly do expect more QE, in one form or another, at some point in the near future. The economic outlook is bleak, and the recent CPI data is pointing to a deflationary scenario. May CPI came in at -0.3% due to falling energy prices. With no fears of inflation on the horizon, the Fed has more runway to go ahead with another program. However, it again bears mentioning that Chairman Bernanke sees diminishing returns from another round of QE, making the risk/reward of adding several hundred billion more dollars to its balance sheet look less enticing.

The economic data backs this up, too. After QE1, GDP grew by 2.8% in FY10 after declining 2.6% in 2009. The unemployment rate improved 500 basis points to 9.4% in FY10, and corporate earnings were up a staggering 39%. After QE2, GPD growth slipped to 1.5% in FY11 and corporate earnings were up a more modest 16%. And now, with Operation Twist expiring, we see that FY12 projections for GDP growth is around 2% (and declining), corporate earnings are expected to only grow by 9% this year, and the unemployment rate just ticked slightly higher to 8.2%. So, while the markets may rejoice at the sound of QE3, it may not actually be the panacea to the economy that some are hoping it to be.

Not only will another round of QE not have the same punch as in the past, but, traders and investors need to keep their focus on what the Investment Rate tells us. In recent articles, I have been consistently pointing to this economic model, which was developed by Thomas Kee, Jr, Founder and President of Stock Traders Daily. Simply put, the Investment Rate is the most accurate leading longer term stock market and economic indicator ever developed. It is currently telling us that, due to a rapidly declining amount of new money available for investments, that we are heading into 3rd major downturn in U.S. history. The model uses demographic studies at its core to measure swings in demand for new investments in stocks, real estate, bonds, and businesses.

Admittedly, this does paint a rather bleak outlook, but if a non-biased, objective, and proactive approach is implemented, investors can still protect themselves and even do well in this environment. Keeping a larger than normal cash balance is prudent, and hedging your portfolio with an instrument like the ProShares UltraShort S&P 500 ETF (NYSE: SDS) makes sense too.

If shorting isn't your cup of tea, looking for high-yield stocks is another way to insulate yourself. I have been an advocate of mortgage REITs, for instance, as the book values of these stocks have been increasing and as investors continue to seek safe-haven investments. Annaly Capital Management (NYSE: NLY) is one to consider with a robust yield of 13% at the moment.

Lastly, investors could look to add some commodity exposure. As noted above, precious metals could be poised to move higher once the Fed definitively announces its next easing program. Outside of metals, though, I tend to gravitate towards the agriculture space for a longer term play on growing population and decreasing farming acreage. Also, if inflation ever does rear its head, food prices could soar. Overall, the future does look bright for the agriculture space, making stocks such as Monsanto (NYSE: MON), which provides seeds and herbicides to farmers, an interesting long term play.

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.