Investors Cheer Return of Quantitative Easing by Fed

The headline on comments by Federal Reserve chief Ben Bernanke at his Jackson Hole retreat in August focused on his comments that the economy is going to be just fine, now, don’t you worry. But his body language and other comments suggested that he would “do what it takes” to keep deflation at bay by using an asset-purchasing process that economists call “quantitative easing,” or QE for short.

We facetiously call this “firing up the printing press,” but more seriously it is about using the Federal Reserve’s limitless balance sheet to buy securities such as Treasuries. This process essentially turns pieces of paper issued by the government (the T bonds) into cash that can flow into the nation’s bloodstream and hopefully then used for productive purposes. Another term for this that you might have heard is “monetizing debt.”

In the future, investors believe that the Fed could also use its balance sheet to support the stock market by buying equities — and conspiracy theorists believe the Fed is already actively engaged in this process by buying S&P 500 futures at key junctures to support its mission of helping the financial and monetary system maintain stability.

I don’t want to get into a big argument on whether this is right or wrong — I just want to tell you that the market loves free money and adores talk about the potential for more QE.

Here are the facts, courtesy of a report this week from the analysts at ISI Group in New York:

After the Bank of Japan implemented QE in 2001, the Nikkei went from 8,000 to 18,000. The BOJ then almost completely withdrew QE in 2006 and the Nikkei went all the way back to 8,000.

After the Fed implemented QE in 2009, the S&P 500 went from 700 to 1,200. Since the Fed has stopped expanding QE, the S&P 500 has declined 12%.

Now listen. When the Fed announced QE last year, few people believed it would significantly lift the stock market. Few today still believe that another round of QE would significantly lift the market. However those that do believe it were trading Friday, and they voted in favor. There’s a new theory afoot which suggests that a key channel by which QE impacts GDP is through stock prices.

Personally I think that the Fed will decide to intervene with QE again to help get employment back on track because there is no stomach in Congress for more fiscal stimulus. Jobless claims are breaking out higher again, which is miserable for households and painful for politicians. With Congress forced to the sidelines by the deficit, policy makers will come to think that QE should shoulder the whole load. I’ve seen estimates it could amount to as much as $1 trillion this time — yes, that’s with a T — and do not doubt for a minute that it could happen.

So the summary is: Although the economy and corporate profits are weakening, the government still has bullets it can shoot to defend confidence in the markets. And it will. So while the market can still suffer an accident in the fall — and the coming week could start off rough — I don’t anticipate anything like the massive sell-off we saw in 2008.

Some wags call this effort to try quantitative easing again ”QE 2,” like the grand old British ocean liner formally called the�RMS Queen Elizabeth 2. Let’s hope our QE2 does not suffer the same fate as that namesake, as the ship formerly owned by Cunard is currently mothballed in Dubai.

GDP Not So Bad

You know by now that second-quarter GDP was revised lower on Friday to a 1.6% annual rate, down from the 2.4% original estimate. Consensus expected +1.3%, so this was considered good news. Either way, the data showed what we already knew: the recovery is losing steam.

However there is one other way to look at the number that is not so grim. Most of the revision was due to some math on trade deficits that don’t really give the best picture of the U.S. economy. The biggest part of the revise came because we imported more than previously thought, and exported less. Which is not so great but that’s been going on a long time.

When you exclude net imports and inventory from the GDP number you get a stat called “real final sales to domestic purchasers” — and that was revised up to 4.4%, from 4.1%. It was the highest number since the first quarter of 2006, and suggests that final domestic demand has picked up. Ned Davis Research analysts say this shows “final domestic demand has picked up, and if sustained will prevent a return of recession.”

Another positive in the report: On a year-over-year basis, before-tax profits were up 39.2% in the second quarter, near their fastest pace since 1983, according to NDR analysts. Domestic non-financial companies’ profits were up 47%, the most since Q4 2002, while financial profits fell. NDR says the data shows that both overall and non-bank profit margins widened to their largest levels since Q4 2006, and are above average for this stage of the business cycle, largely because of a 5.2% reduction in labor and input costs.

So now you can see that if you peer deeper under the hood of these reports, and don’t just accept the quick media once-over, there were some remarkable positives.

What I would like to make sure you understand is that the media narrative about the economy being terrible is not fully accurate. And also we need to recognize that a slowing economy is not the same as a recession. All that the best companies and regions need to be successful is the most modest amount of baseline growth.

There have been many great stock market advances in history when the economy was remarkably weak. One of the most vivid examples was the second and third quarters of 1995, highlighted in the first chart above in the red rectangle.

GDP growth slowed to around 1% then only a year after the 1994 recession, and there were rampant fears of another follow-on recession, or what people now call a “double dip” — just like now. Meanwhile, however, the stock market went straight up, as the Fed was on the case, debt securitization was just getting started and a five-year boom got underway.

The bottom line is that the economy is weak but not a basket case. And in any case, a slowdown in GDP growth does not have to lead directly to a decline in stock prices. The economy and stocks sometimes move in synch, but more often they each march to their own drummer. And if the Fed launches QE II, the market can really take off — at least for awhile.

For more ideas like this, check out Jon Markman’s Traders Advantage or Strategic Advantage advisory services.

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