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QE2 and the Markets

|Includes: BAC, C, Alphabet Inc. (GOOG), JPM
Friday I pondered why on earth the market would rage higher in my article Friday’s Rally Makes No Sense at All. Most explanations just didn’t cut it for me. Now I think I have found the answer and that is the growing belief that the Fed will move forward with a second round of Quantitative Easing (playfully called QE2).
 
Why does the Fed want to go down this road? Because of the rising possibility of deflation. Note that if this was just about having a little recession the Fed would not act. They are deathly afraid of deflation and the possibility that we have a lost decade or two like Japan. So they will use all the weapons at their disposal to try and prevent this from happening.
 
How do they do QE2 with the Fed Funds rate basically at zero? The game plan would be for the Fed to buy tons of long dated Treasury bonds. This should lower Treasury rates and provide a little spark to the economy. That’s because lower rates makes borrowing cheaper. But also it makes all forms of holding cash very unattractive. So people seeking more return should be willing to take on more risk. That is preferably in the form of expanding current businesses or starting new ones to get a better rate of return on their money. That is stimulative to the economy.  
 
A side effect of QE2 is that the dollar will most likely also drop versus other currencies making our exports more attractive in world markets. That sounds attractive on the surface. Yet in the long run a stronger currency is almost always preferred as it’s a sign of a healthy economy and responsible government (I can hear some chuckling by some on that last part).
 
So how is this good news for the stock market making it rise on Friday? If rates on Treasuries go lower, then it makes stocks all that more attractive by comparison. Especially with the impressive dividends being paid by your average S&P company these days. If you remember, I pointed this out when the 10 year Treasury got down under 2.7% making the stock market at Dow 10,000 a downright steal. Gladly we guessed right on that one. So if rates go to like 2.3% you can see why stocks would even be that much more attractive. .   
 
Again, this is what the Fed “may do” if they think we are moving too close to a period of deflation. And if they take these actions there is no proof that it will work as intended. That is why I don’t think the market should continue to move much higher on this news. Maybe take a shot at Dow 11,000, but then investors should be in a wait and see mode for Q3 earnings and GDP.
 
My concern about this earnings season is that it may be of the “buy on rumor sell on news” variety. Meaning that we rally into earnings and sell off on the news. And that is a sell off even if the reports are good. Because after rallying 8-10%, just being good probably won’t be good enough to rally further. That is the way that January 2010 earnings season worked out.
 
Of course if earnings and GDP are WELL above expectations, then certainly stocks would continue their advance and investors should move closer to 100% long.
 
 
My Two Cents
(During the day I read many other investment articles of interest. Here are links to some new ones with my 2 cents added underneath).
 
Very few people are expecting exceptional GDP growth. At best we will have a muddle through economy and with that muddle through style equity returns. Now consider that cash or Treasuries pay near nothing. So against this backdrop you can see the appeal of dividend paying stocks to generate a decent return.
 
GOOG is no longer a high growth stock. So those investors expecting 30%+ growth sold their shares. Now a new crop of folks are buying up GOOG realizing this is an attractive large cap growth stock that will probably grow earnings 15-20% per year. When you consider a reasonable valuation for shares given these more reasonable growth prospects plus cash on hand, then you could easily see shares $600 - 650.
 
I personally have stayed away from the banks and just placed my bets elsewhere. To me the banks and the Gov are acting like my 8 and 10 year daughters.

How's that? When we ask them to clean up their rooms, they scurry around as fast as possible and throw all their stuff in the closets. On the surface the room is clean. Then when you open up the closets you get buried.

That's why I stay away from the bank stocks.
 
Best,
 
Steve


Disclosure: I own shares of Google