November 28, 2010

Debunking Myths about QE2

There's much that QE2 is supposed to do for you. But will it?

Ben Bernanke, current captain of the Federal Reserve, is praised for having steered the ship out of stormy waters. Not too long ago, Alan Greenspan enjoyed the same praise and recognition. Greenspan’s financial alchemy averted a deep and prolonged post-tech bust bear market.

How? Nothing makes investors happier than rising prices. Lower interest rates and easy money brought about the biggest real estate boom in decades. You probably know where this is going … the real estate boom didn’t last. In fact, it ended abruptly and took stocks with it.

Where did Greenspan go wrong? He tried to stop the burst of one bubble by creating another. What is Bernanke trying to do know? As per his own admission, he wants to inflate the stock market. After all, if stocks go up, everyone is happy. In essence he’s creating another bubble.

If you think rising stock prices are validated, consider how unemployment, earnings and dividends today compare to a few years ago.

First off, unemployment. In August 2007, when the Fed lowered the discount rate, the unemployment rate was 4.7%.

December 2008: The Fed reduced rates to just north of zero, when the unemployment rate stood at 7.4%.

March 2009: Fed launched QE1 with unemployment at 8.6%.

November 2010: Fed rolled out QE2, and unemployment stands at 9.6%.

How about earnings? Despite all economic trouble and European debt woes, 2011 corporate earnings are forecasted to surpass their 2007 all-time high. Does that sound right?

How about dividends? Dividends are probably the purest measure of value. Companies are allowed to display their financial prowess by “seducing” investors with juicy dividend payments. Dividends are cash in your pocket and can’t be fudged. Since the March 2009 lows, stocks rallied as much as 84 percent.

A true economic recovery would see dividend payout increases at least somewhat proportionally to stock prices. In March 2009 the dividend yield for the S&P 500 composite was 3.6%. By multiplying 3.6% with the March 2009 low of 666 we arrive at a dividend yield of 23.98 points.

In October 2010, the S&P yielded 1.97%, which represented 23.64 points. This measure, as simple as it may be, illustrates that there’s been next to zero net dividend growth since the March 2009 lows (in fact, the yield dropped from 23.98 points to 23.64 points), even though stocks have rallied more than 80%.

By using the most simplistic of indictors (history and dividend yields), we have debunked a major QE2 myth; QE2 does little for the economy, but does wonders and Wall Street’s stock portfolios.

There’s one more thing we have to debunk. Inflation measured by the Consumer Price Index (CPI) has dropped steadily since mid-2008, when the Federal Reserve went on a shopping spree. QE2 causes asset inflation, but doesn’t prevent a deflationary spiral.

The big question is, how should you approach investing in a QE2-sponsored bubble? All is good as long as prices go up. As we’ve seen several times over the past decade, price can tumble in a hurry and cause severe pain.

For right now, there’s nothing wrong with enjoying the rally with trailing sell-stops. The ETF Profit Strategy Newsletterconsistently provides the most updated support and resistance levels, which help you maximize your gains and at the same time know when to pull the plug.

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