The Fed's QE3 move this week, in four words: good enough for now.
Bernanke gave investors what they wanted, and what they have been expecting for months now. Bernanke is a smart guy -- he knows what investors want to hear, and he has usually given them just enough to prevent disappointment and boost confidence in the markets and economy. Now, with the Fed and Bernanke signaling further stimulus and added monetary support, stocks and risk assets may be good in the short-term.
- Risk: Added stimulus and "unlimited" QE greatly increases the risks of financial shocks, and continues to pile on debt to the government and Fed's balance sheet, which is already at record-highs and at extremely unsustainable levels.
- 10 percent: Stocks are now less than 10 percent away from the 2007 all-time highs. We've broken out above major resistance and have reached 4-year highs, but why take such risk when we're only 7 percent away from major overhead resistance? As we approach that level, sellers may come in and the market may hit a brick wall. The upside is less than 10 percent, and the downside could be 20-50 percent. Better to wait and see if this rally can be sustained.
- China, Europe, Middle East: There is a massive slowdown in China that is getting worse every day. Europe is still in the midst of a financial crisis that is yet to be resolved. And the Middle East tensions just got worse. World markets are intertwined nowadays -- it is highly unlikely that the U.S. could avoid a recession when the rest of the world suffers. If China, Europe, and the Middle East do not solve their problems, and slip into recession, the U.S. will very likely be dragged down with them -- regardless of central bank intervention and support.
- QE Timing: Unlike previous QEs, which were announced near market bottoms and helped boost stocks, Bernanke just announced QE3 at a 4-year high! Since most investors were expecting QE3 or added stimulus, and bought stocks for months beforehand in anticipation, most of the QE3 expectations may already be factored in. It's true that Bernanke couldn't disappoint markets or we'd be in big trouble, but since he was forced to act at a market top, there may not be much room left to rise.
- Verbal Weapons: It seems to be great for the market that QE3 is now "unlimited" and the Fed could provide as much stimulus as necessary to improve employment and the economy, but the Fed may now be out of "verbal weapons." Up until now, the simple expectation and anticipation of added QE was enough to boost stocks and increase investor confidence. Bernanke was able to please investors simply by saying that "the Fed could and will do whatever is necessary to support the economy if the situation calls for it." He was able to push off the actual QE announcements just by saying that he could do it if he needed to. However, now that QE3 is "unlimited," there is no QE4 possible because QE3 already includes all future QE. Bernanke is now no longer able to pump the market and increase investor confidence with his words alone -- now, the market needs to see him act in order have faith in the Fed's policies. If Bernanke's QE3 plan doesn't start to work soon, and the economy fails to improve as expected, the Fed may be left helpless and out of bullets.
If the economy doesn't improve over the next year, QE3 will be considered a failure and recessionary forces will win. The Fed has "doubled down" on its QE bets: QE1 and QE2 were not enough to engender a sustainable recovery, and the Fed has dug itself into the deepest hole with QE3. If QE3 doesn't bring the economy back, the party is likely over.
50 / 50
It's as if a person bet $1,000 in roulette -- all on black. He then lost the entire bet because it turned out to be red. Then, to make his money back and avoid the big $1,000 loss, he borrowed another $1,000 from his friend in order to "double down" and come out even. Using this borrowed money (debt), he then bets it all on black again. Yet we don't know if he'll win. If he wins, he's recovered his losses and can walk away unharmed; but if he loses, he's lost double what he lost in the first place, and he's also completely screwed his friend.
The Fed has done exactly that -- only instead of a $1,000 gamble, it's more like a few trillion dollars.
How To Invest Now
The Fed's stimulus and support of the markets may help stocks in the short-term, and could even help the economy recover in a sustainable way, but there are tremendous risks still ahead, so I cannot recommend that investors should be bullish here. With the markets up over 100 percent since the 2009 bottom, and with the rest of the global economy continuously weakening, the risks outweigh the rewards here. Even worse, we're less than 10 percent away from major overhead resistance at the 2007 all-time-highs. It pays to wait and see.
However, we know that most investors still like to look for good investment opportunities, and I can't say there aren't any. In fact, there are a number of investment themes and companies that I currently like. But in order to limit the risk of a big disappointment and falling stock prices, we prefer to either protect our long positions or to "pair trade." Pair trading allows us to short or avoid companies and sectors we don't like while buying companies and sectors we do like.
In other words, we bet against one thing and buy another -- that way, we aim to profit as the investments we like "outperform" the investments we don't like. We don't even need our favorite investments to do well, and we don't even need the investments we hate to do poorly -- we just need the ones we like to do better than the ones we don't like.
To make it easy, here are our bearish and bullish picks:
- Gold (NYSEARCA:GLD) and Gold Miners (NYSEARCA:GDX) - As I've mentioned on numerous occasions, gold is in a bubble that will burst (See: my book). We are still below the September 2011 peak of over $1900, and even if we make new highs, we will see a sharp plunge as gold makes its way back down toward $700. I know that sounds extreme to most investors, but the evidence is there in my book. And even if gold continues to rise, I have laid out plenty of ways to profit from other commodities, sectors, and stocks that will outperform gold over the next years. So far, platinum, diamonds, and housing (which I emphasized in the book), have all greatly outperformed gold.
- Oil (NYSEARCA:OIL) below $100-$120 - Oil is still our most important energy source, and could spike if the Fed creates enough inflation, or if Middle East tensions create a panic. However, high oil prices can lead to recessions and the government, therefore, wants to suppress oil prices in order to help the economy. Moreover, oil is approaching the big psychological level of $100, which will bring sellers. It's also below the $115 level of early 2011, which I think may be the peak for years to come (also predicted in my book).
- Over-hyped Technology - It is obvious to everyone that technology is extremely popular over the past few years: Apple (NASDAQ:AAPL) is at record highs and seems to be "unstoppable" and the "best company in the world," Facebook (NASDAQ:FB) was valued at $100 billion and promises a bright future for social media, and the IPO frenzy has been ridiculous, to say the least. But as we've already seen, Facebook has been a tremendous flop and is failing at actually monetizing its business; Groupon (NASDAQ:GRPN) and Zynga (NASDAQ:ZNGA) benefited from huge enthusiasm as promising technology IPOs, but are completely failing as stocks; and Apple is becoming less and less impressive while also facing growing competition (such as Samsung), which threatens its once-dominant No.1 position. I can't recommend that investors short these over-hyped technology stocks yet, since FB and others have already seen such massive declines, and because Apple still has upward momentum. But I can definitely recommend that investors avoid them.
- China - China (NYSEARCA:FXI) is undergoing a massive slowdown, as growth is slipping rapidly, and as its stock market has performed very poorly for two years now. A housing bubble may be bursting, a financial shock is possible, and at the very least, huge expectations about China's bright future will likely not be met. Avoid China and Chinese stocks.
- Platinum - In my book, I recommended a "platinum vs. gold" pair trade. Platinum has historically been more expensive than gold: Platinum records, platinum jewelry, and physical platinum itself have been way more luxurious and expensive than simple gold. All of a sudden, gold was trading at $1600, while platinum was only at $1400. Since platinum has historically been more expensive, and I believe will be more expensive over the next years, buying platinum (NYSEARCA:PPLT) while shorting gold is almost a guaranteed win-win. Platinum will fall too if gold falls, but it will eventually be more expensive (and over the past three months, platinum is up more than double gold's move).
- Diamonds - I also told investors to "Forget Gold, Buy Diamonds." Since gold has been up so much while diamonds have lagged behind, I recommended investors short gold and buy diamonds. However, since there was no diamond ETF, I recommended investors look into diamond companies such as Zales (NYSE:ZLC), Blue Nile (NASDAQ:NILE), and Harry Winston Diamond (HWD). Zales was my favorite; and guess what -- it's up over 100% since my book was published. I can't recommend it now after such a massive move, but it's definitely a stock to keep an eye on.
- Diversified Miners - For those investors who still want gold exposure, but also want exposure to diamonds, aluminum, uranium, copper, and other minerals, I recommend companies like Rio Tinto (NYSE:RIO) and BHP Billiton (NYSE:BHP). Though these companies will fall if gold falls, they are safer than most gold-only miners because they are diversified among a bunch of commodities. Neither company looks absolutely great financially, but BHP has a PE of 11 and both companies pay a nice dividend of around 3 percent.
- Housing - After the housing bubble collapse, I viewed the housing market as a good "value play." I don't know if housing prices are absolutely safe here (though they're up for eight months straight already), but I do think housing is a safer investment than many other asset classes. In my book, I recommended that investors bet on housing through the homebuilders ETF (NYSEARCA:XHB) rather than physical homes. My favorite play was Hovnanian (NYSE:HOV), which is now up 100 percent since my book was published (and close to 300 percent since the first published version of my book). After such a huge run in the homebuilders, investors need to be careful. But like the diamond companies, this is a sector to watch.
- Natural Gas - Perhaps my favorite bullish call right now, natural gas is the buy of the decade. I think that natural gas will outperform almost every asset class over the next years, and I love it as an investment right now. To profit from this prediction, I recommend either the natural gas ETF (NYSEARCA:UNG) or specific companies that I like such as Devon Energy (NYSE:DVN) and EXCO Resources (NYSE:XCO). Devon and EXCO are my favorites (Devon being the larger, dividend-paying company and EXCO being the more speculative, but natgas-leveraged company), but investors should also keep an eye on Chesapeake (NYSE:CHK) and Clean Energy Fuels (NASDAQ:CLNE) -- which have billionaire support from Carl Icahn and T. Boone Pickens -- as well as companies like Encana (NYSE:ECA) and Cheniere Energy (NYSEMKT:LNG), which provide investors with good exposure to liquefied natural gas.
There is definitely money to be made through these pair-trades and selective stock picking, but be careful.
Disclosure: I am long ZLC, DVN, and I may initiate positions in GDX, HOV, BHP, RIO, and XCO. 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.