Aninvesting maxim, when turned on its head, can still be true.
In decades past, investors were told that you "can't fightthe Fed
," which meant that when the Federal Reserve was boosting interest
rates, markets would be hard-pressed to rally.
These days, that adage has a whole new meaning. The series
ofquantitative easing (QE) measures appear to be a huge factor
behind our steadily-rising markets, and anyone fighting
theliquidity the Fed has delivered has been on the wrong side of
The Fed's efforts have propelled all assets higher, creating
real pain for short sellers and othermarket bears. Look for more of
the same in coming months. But soon thereafter, the Fed -- and the
market -- could swiftly shift direction.
So you need to keep an eye on the exits.
What drivesstocks ?
There are two key drivers ofstock prices:Corporate profits and the
expansion or contraction in the perceived value of a
company'searnings streams and assets.
Let's break them down…
Profits are often good predictors of stocks prices and have
risen about 5.5% annually during the past 35 years on an
inflation-adjustedbasis , according to Morgan Stanley. Stocks have
done poorly right at times when profit growth is expected to slow,
and stocks have rallied when profit growth is expected to
It's notable that today, real earnings growth has begun to
decelerate even as the market rises higher.
Even as profit growth in the S&P 500 slowed to 6% in 2012,
theindex rallied an impressive 13%. And even as profit growth is
expected to slow a bit more in 2013 (the consensus forecast
anticipates a 5% rise in S&P 500 profits, though some
strategists say we'll see zero profit growth this year), the
S&P 500 has already tacked on another 5% gain in just the first
month of 2013.
The fact that stocks are rising higher even as profit growth is
slowing can be explained away by the other factor behind the
market: Asset valuations. Simplyput , the Fed has added a $1
trillion punch to theeconomy through the variousQE programs, which
is leading toasset price inflation .
Strategists at Morgan Stanley draw a direct line between cause
"Assetappreciation increased during QE1 and its extension, then
fell (reaching 20%depreciation in August 2010); appreciation
resumed during QE2, then dropped off in Summer 2011; with Twist and
QE 3, appreciation resumed again. During QE2 and the first nine
months of Twist, there appeared to be diminishing returns to QE
(i.e., lower slopes on asset appreciation). Starting in July 2012,
however,equity multiples began rising much faster. Since the start
of QE3, asset appreciation has remained high - currently at 11% per
Indeed since the middle of May 2012, the S&P 500 has risen
16%. That's an annualized gain approaching 25%, even as earnings
growth headwinds have materialized during the past threequarters
Stocks haven't been the onlybeneficiary of the Fed's liquidity
moves. The proceeds from asset sales to the Fed have also found
their way into the commodities markets. And that's fueled
double-digit six-month gains across the board.
Forget Gold Or Silver: This Metal Is Headed For A
Classic Supply-Driven Rally
Of course, the Fed is hoping that the asset-boosting moveswill
have a stimulative effect on the economy, leading economic activity
to expand and corporate profits to start rising at an accelerating
Will the Fed succeed? We'll soon find out. Morgan Stanley's
strategists figure that "there are two or three quarters left until
judgment gets passed -- either the Fed is successful andEPS and the
economy reaccelerate, or the market is likely to sharply
These strategists don't even touch upon the other major risk
that an aggressive Fed policy entails. Once the Fed stops
supporting the economy with its QE efforts, investors will start to
wonder about the effect that the eventual sale of $1 trillion in
Fed-acquiredbonds will have on the economy once they are put up for
sale. This tidalwave of bonds coming on the market could crowd out
otherbond issuers, raising the cost of debt for all
Talk about "taking away the punch bowl." This maxim may soon
have a greater effect than many suspect.
It's almost hard to grasp the size of the total QE program.
Here's a brief timeline:
&bull ; November 2008: the Fed begins to buy billions
inmortgage-backed securities (MBS) . By June 2010, the Fed carried
$2.1 trillion in bank debt,MBS and U.S. TreasuryNotes on itsbalance
• The Fed let that total balance drop in the summer of 2010 as
bonds matured and weren't replaced, and that negative liquidity may
have played a role in the market's 10% drop that summer.
• In November 2010, the Fed announced QE2, leading to the
purchase of $600 billion in Treasury Securities by the following
• In September 2012, the Fed announced QE3, which called for a
more modest $40 billion purchase of MBS. Those actions have again
led investors to sell their MBS and other bond holdings and
re-invest the proceeds into more speculative assets such as
The sum total of QE1, QE2 and QE3? It's hard to determine a
preciseaccounting , but the Fed is likely holding roughly $2
trillion of assets. How this position will unwind remains a bit of
a mystery. Before we even get there, some investors are wondering
whether the Fed will deliver another treat in the form of QE4. But
recent comments from the bank suggest that enough has been done on
Instead, the focus will soon shift to gauge what will happen to
stocks once the QE3 buying wraps up this spring, and the prospect
of QE4 begins to fade.
Risks to Consider:
Strategistsnote a "Wall of Worry" for good reason. That wall is
built on the backs of the various QE programs, and disassembling
the Fed's bloated balance sheet will require surgical
Action to Take -->
This is not acall to sell all of your stocks. Indeed stocks could
rally into this spring, if current momentum is any guide. Instead,
it's an early warning to book profits in some of your
bestinvestments , especially those that now trade at or above any
sort of fundamental underpinning.
It's time to play on your heels,
holding defensive stocks
that tend to hold up better in tough markets. These are stocks that
sport solid and defensibledividend yields, stocks that trade
belowbook value , or at a very lowmultiple tocash flow .
-- David Sterman
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David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC does not
hold positions in any securities mentioned in this article.
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