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Could Bernanke Send Stocks Soaring (Again)?

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After a solid rebound through the winter and spring of 2009-2010, the U.S.economy began to lose steam. As spring turned into summer in 2010, investors grew increasingly concerned the U.S. economy would slip right back into recession , known as a "double dip." The S&P 500, which had moved back up above 1,200 in the spring, steadily fell to 1,050 by late August.

Behind closed doors, Ben Bernanke and other members of the Federal Reserve grew alarmed and cooked up a remedy, known as QE2 (or the second round of Quantitative Easing). This is essentially where the Fed bought back many bonds in hopes the bond sellers would redeploy their cash into more productive areas of the economy. (Owning bonds is to economic activity as what sitting on your hands is to exercise.)

Word spread that QE2 would soon be announced and it kicked off a powerful rally around Labor Day, though the actual details and implementation of QE2 wouldn't arrive until November, which I wrote about previously .

The Fed continued with the program and completed the bond buyback in June 2011, but signs emerged far earlier that it wasn't fulfilling the stated goal of boosting spending in productive parts of the economy and was instead simply rocket fuel for stocks and many commodities. From August 31, 2010 to February 18, 2011, the S&P 500 surged a heady 28%. It's not like the economy was getting drastically better -- it was simply the QE2 cash looking to find a home. The lack of economic oomph was one of the key reasons I turned bearish on the market in late January (though the market wouldn't peak for another three weeks).

Well, get ready for QE3. The same playbook still applies: Buy now, sell later. The stock market posted early gains Monday on rumors that Ben Bernanke may make a major announcement this coming Friday, Aug. 26, when he meets with Fed governors in Jackson Hole, Wyo., for an annual symposium. This was the venue where Bernanke first spoke about QE2 last year.

Right now it's unclear whether Bernanke will simply speak about the weapons left in the Fed's arsenal (which in the past has been a precursor to eventual action) or whether he'll act right away. Regardless of which he chooses, the stock markets are likely to react very positively simply because investors know that there will be yet more liquidity sloshing around in search of something to buy.

QE3 could differ from QE2 in some fundamental ways. Instead of simply buying back bonds (and putting cash back into the hands of potential investors), the Fed could instead replace short-term bonds with longer-dated ones (e.g. buy back two-years and sell-10-years). Or it could cut interest rates paid to banks that hold capital in excess of minimum capital requirements.

Regardless of the specific steps the Fed takes, the net effect should be the same as QE2: An excuse to buy stocks as the Fed signals an intention to keep the economic ball rolling. With the knowledge any deeper economic weakness in the months to come will be met with corresponding stimulation, investors need not focus on any sort of doomsday scenario for the economy. After the recent massive sell-off that has created hundreds of stock bargains, this all could put investors back into a buying mood.

Yet as noted above, just because the Fed may discuss steps to take, it may not act right away. So expect plenty of volatility this Friday as strategists parse every aspect of Bernanke's speech.

Risks to consider: There's also a chance Bernanke chooses the opposite tack, highlighting bright signs in the economy. After all, auto sales remain OK, retailers just delivered decent sales results, energy prices are easing, and we still may avert any further economic slowdown. This would be a bullish tone for the economy, but bad for stocks, which seem to really want to see a Fed-induced cardiac shock to the system that revives animal spirits.

Action to Take --> If QE2 is any guide, then the Fed's words and deeds may indeed spark a solid rally. But this would be no time to get complacent. The boost from QE2 provided a six-month rally, though this one may be shorter-lived. So if we do get any sort of rally, you should look at it as a time to harvest profits. So many stocks are below their 50 and 200-day moving averages, and if they rally well above those thresholds, you should switch to sell mode, raising ample cash levels for the next time the market whipsaws investors.

-- David Sterman

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Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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