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Are Expectations of QE3 Baked into Stock Prices?

Are Expectations of QE3 Baked into Stock Prices?     
Ron DeLegge, Editor
February 10, 2012

The Federal Reserve has thrown the kitchen sink at the U.S. economy and then some. A third round of quantitative easing is still in the cards, but do stock prices already reflect it? 


Quantitative Easing 101
Since December 2008 the Federal Reserve Bank has been engaged in various financial stimulus programs which have been called “quantitative easing” or “QE.” The basic idea is to jumpstart the economy, help the housing market recovery, increase liquidity, and stimulate the job market.

The Fed began its first round of experimenting (QE1) with a multi-billion dollar buying spree of toxic debt assets. It was subsequently followed up with a second round of financial engineering that involved buying U.S. Treasuries (NYSEArca: TLH).QE2 ran from November 2010 to June 2011.

In September 2011, the Fed followed up with a plan to shift money from maturing short-term Treasuries (NYSEArca: SHV) to long-term U.S. Treasuries (NYSEArca: TLT). Up until now, interest rates have obeyed the Fed’s command. On September 1, the yield on 10-year Treasury notes (NYSEArca: IEF) was 2.13% compared to 1.97%.

Another round of asset purchases by the Fed or “QE3” is expected, but what will it do?   

Two Distinct Economies
“As long as I’m here, I will do everything I can to help the Federal Reserve achieve its dual mandate of price stability and maximum employment,” said Ben Bernanke, Federal Reserve Chairman. Interestingly, the Fed’s monetary policies have done neither.

Asset prices have not remained “stable” but rather, have become distorted.  

Since 2009, the price of stocks (NYSEArca: TMW) have soared. Last year, government bonds (NYSEArca: TLT) also surged and had their best year since the onset of the 2008 financial crisis. Riskier assets like junk bonds (NYSEArca: JNK) and highly leveraged real estate investment trusts REITs (NYSEArca: VNQ) and mortgage REITs (NYSEArca: REM) have done well too. Although each of these areas has responded favorably to the Fed’s engineering, the treatment ultimately failed to reach its intended patient - the broader economy. 

The headline jobless rate of 8.3% unemployment drastically understates the dire situation in the job market. Actually, the 8.3% figure, which Bernanke quotes and the media says has “fallen,” is not a complete picture.

The only figure that remotely comes close to the true jobless rate in this country is the Bureau of Labor Statistics’ U-6 figure. This number is currently at 15.1% and is a far more accurate because it includes discouraged workers, marginally attached workers, plus workers that are forced to work part-time because they are not able to find a full-time job. And if we add another important category of workers to the U-6 numbers – unemployed self-employed individuals -  the real nationwide unemployment rate is probably closer to 18%. (An example of a “self-employed unemployed worker” would be a real estate agent that hasn’t been able to manufacture enough income from selling properties.)

 

The jobless rate still remains stubbornly high and there can be no real economic recovery without larger declines. Going back to January 2011, the U-6 unemployment figure was 16.1% compared to 15.1% in January 2012.

In short, the stock market economy is doing well, but the broader economy still has considerable catching up to do.

'Stress Testing' the Fed  
How financially sound is the Federal Reserve? If the Fed’s main job is to help others during times of financial crisis, it’s perfectly reasonable to expect that it should be in top notch financially fit condition.

Before the onset of economic recession, the Fed held between $700-800 billion in U.S. Treasuries on its balance sheet. In late 2008, it started buying $600 billion in toxic mortgage-backed securities. By the spring of 2009, it held approximately $1.75 trillion in bank debt (NYSEArca: KBE), sub-prime mortgage debt and other securities.

Today, the Fed is sitting on $1.66 trillion in U.S. Treasuries and $866 billion in mortgage backed securities (NYSEArca: MBB). By absorbing trillions in U.S. government and mortgage debt, the Fed has taken on liabilities much larger than any financial institution or banking corporation could possibly handle. But in doing so, it has also put its own financial situation at great risk. It’s questionable whether the Fed’s exit strategy will be as smooth as its entry.

Preparing for QE3
The Federal Reserve’s laboratory experiments on the U.S. economy have had mixed results. While asset prices have run ahead, the real economy is still stalling.  

The February 2012 ETF Profit Strategy Newsletter analyzes how market forces greater than the Federal Reserve are already forming. These forces will have a direct impact on the future direction of securities prices.

Intervening in the financial system (NYSEArca: XLF) has never been a problem for the Fed and the past several years have shown it. But their exit strategy carries lots of unknown risks and unanswered questions. 

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