Fed Stimulus & the Markets: A Repeat of 2010?

The stock market without QE liquidity is like a junkie without the next fix.

Hope is not an investment strategy. Yet, the stock market’s fate seems to be closely tied to Bernanke’s Jackson Hole comments and the hope of QE3. Bernanke’s 2010 Jackson Hole comments breathed life into the markets. Did his 2011 Jackson Hole pep talk deliver the needed hope or was it another nail in the coffin?

Below is a thorough analysis of Bernanke’s 2011 speech along with a comparison to the 2010 speech. More importantly, we will discuss what the market thinks the odds of higher prices are.

The parallels between the timing of the 2010 and 2011 speeches and the stock market’s (VTI) performance are quite amazing. It explains why investors put their hope in QE3.

Parallels: For Better, For Worse

Amidst an avalanche of hope and optimism, the S&P 500 (SPY) Dow Jones Industrials (DIA) and Nasdaq (QQQ) peaked on April 26, 2010, with the S&P at 1,220. On April 16, 2010, the ETF Profit Strategy Newsletter warned that: “The combination of sentiment extremes clearly point towards a correction. The upside potential is much more limited compared to the massive downside risk.”

From April to July, 2010, the S&P tumbled 17% and delivered a never-before-seen “Flash Crash.” It was Bernanke’s August 27, 2010, speech that marked a turnaround for stocks.

In 2011, the major indexes peaked on May 2 at 1,371. The ETF Profit Strategy Newsletter warned of an impending top on April 3, 2011: “A major market top is forming. In terms of resistance levels, the 1,369 – 1,382 range is a strong candidate for a reversal of potentially historic proportions.”  

So far, the S&P lost as much as 19%. Will Bernanke’s speech mark another turnaround?

2010 vs. 2011

Today’s Bernanke speech fills 11 pages. He spends about four pages talking about how bad the economy is, four pages on why the Great America will come back and three pages on suggestions for lawmakers.

In other words, 80% of Bernanke’s speech could be summed up like this: “We have learned that the recession was even deeper and the recovery even weaker than we had thought. With respect to the longer-run prospects, however, my own view is more optimistic.”

The only statement pertaining to a potential QE3 was this one: “In addition to refining our forward guidance, the Federal Reserve has a range of tools that could be used to provide additional monetary stimulus. We discussed the relative merits and costs of such tools at our August meeting.

“We will continue to consider those and other pertinent issues, including of course economic and financial developments, at our meeting in September, which has been scheduled for two days (the 20th and the 21st) instead of one to allow a fuller discussion,” he continues. “The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools as appropriate to promote a stronger economic recovery in a context of price stability.”

As comparison, here are the words that sent stocks soaring in 2010: “The FOMC is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate. Regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery.

“A first option for providing additional monetary accommodation, if necessary, is to expand the Federal Reserve's holdings of longer-term securities,” he said a year ago. “I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions.”

QE3: What to Expect

No doubt QE2 was a huge driving force behind stocks – while it lasted. But today, stocks trade lower than they did at the onset of QE2. If QE2 couldn’t provide lasting benefits, why should QE3? Does any form or shape of QE provide a lasting benefit?

The stock market without QE liquidity is like a junkie without the next fix. Today’s revision of the GDP shows just how bad of shape the economy is in despite the help of QE2.

GDP was recently revised downward for the second time. The economy advanced just 0.4% in the first quarter of 2011. Keep in mind that the stock market was up as much as 5% in Q1.

QE provides liquidity, but that’s it. What happens when that liquidity dries up?

The May 20 ETF Profit Strategy Newsletter wanted to find out what will happen when QE2 ends in June, looking at the S&P vs.  two sources of cash flow (available margin and mutual fund cash levels) independent of QE2.

In short, there was no cash on the sidelines. And the newsletter showed what happened the last time available cash levels were as low as in May – the market crashed.

Here’s the newsletter’s conclusion: “The numbers allow for only one logical conclusion. Without the generous monetary policy (QE2 is slated to end June 30) there is very little new cash left to drive stock prices higher. Without that cash fix the market will crash like an addict forced to go cold turkey.”

QE & Technicals

Technicals supported this outlook. And, if you look at data referred to in the above-mentioned April 3 ETF Profit Strategy Newsletter, the projected upside target was met in April, and the risk of a sell off was high.

The end of QE2 met up with poor seasonality, a major head-and-shoulders top, a Dow Theory bearish non-confirmation, and the break of a multi-year support line for a perfect storm.

Is the storm over? Nobody knows if and in what shape QE3 will appear. We’ve been conditioned to respect any form of QE and it would be foolish to ignore its potential effect. However, the market tends to do the unexpected.

While we don’t know the outcome, we know the expectation is that stocks will rally on news of QE3. The unexpected would be the opposite – falling stocks and a rising VIX.

The latest ETF Profit Strategy Newsletter features a comprehensive forecast for the remainder of 2011 along with target levels for this rally and the 2011 bottom. The newsletter combines fundamental, technical, valuation and sentiment research to formulate its forecast and recommendations. Hope is not an investment strategy.

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