From the November 2012 issue of Research Magazine • Subscribe!

A Stimulus-Crazed World

Can central bankers reflate the world to prosperity? Probably not, but that still hasn’t stopped them from trying anyway. 

The Federal Reserve’s unveiling of QE3 with no scheduled ending is generally the same path being forged by Europe, China, Japan and Brazil. It’s a last ditch effort in a vicious cycle of too much credit, too much spending and not enough common sense.

Along the way, ETFs linked to stocks, bonds, real estate and commodities have surged. How much longer will this continue? How can advisors protect and grow client assets? 

It’s no secret that central banks around the globe are taking aggressive steps to ease monetary policy and bolster their economies. In Europe, the ECB introduced a plan to buy unlimited quantities of bonds from troubled eurozone members. The Bank of Japan increased its asset purchase program to 80 trillion yen. The People’s Bank of China has cut benchmark interest rates twice since June to encourage bank lending and increase liquidity. 

This type of inflationary behavior is not without consequence. In the short run, it may provide some temporary relief. But the longer-term ramifications are higher prices and market instability. It’s important to understand where the puck is headed, before it gets there. 

The introduction of “QE” or “quantitative easing” into the common person’s vernacular began with the 2008 financial crisis and the “Great Recession” that followed it. The Federal Reserve’s objective in keeping interest rates artificially low and making large scale asset purchases was to help the broader economy. 

Before the financial crisis, the Federal Reserve’s balance sheet was large but manageable. Today, the Fed’s balance sheet has jumped from $900 billion in 2007 to almost $3 trillion today. 

Past versions of QE worked like a charm because they calmed fragile markets from falling into a sink hole. QE3, however, is not like the others. It came just as stocks crossed above their multiyear highs and, for that reason, is far more subject to the law of diminishing returns. Has the Fed overplayed its hand? And if it has, who will bail out the Fed, if and when, the chickens come home to roost? 

The stability of central banks shouldn’t be taken for granted. The Fed was born in 1913 as a result of the Panic of 1907. It is actually the third central banking experiment in the U.S. Its predecessors were the First Bank of the United States (1791-1811) and Second Bank of the United States (1816-1836). Put another way, the history of central banks is shaky, which rightly makes us question their future viability.

QE Rewind 

QE1 began in 2008 and was followed by QE2, which involved the Fed buying around $75 billion a month in government bonds. In 2011, Operation Twist was introduced and led to the Fed’s $400 billion switch from short-term Treasury bonds into long-term Treasuries (TLT). How did markets react?

The S&P (SPY) rallied 37% from the first installment of QE1 (Nov. 2008) and 51% from the expanded QE1 (March 2009) to the end of QE1 (March 2010).

The market was already extended when QE2 went live, but was still able to add another 11% until QE2 ended on June 30, 2011.

After the QE3 announcement, the S&P jumped again and is less than 10% away from its all-time high of 1,565 set on Oct. 9, 2007.

Assault on Wealth

Despite trillions of dollars of liquidity injected into the financial system, the erosion of wealth has continued. The median income for American households (around $50,000) has been largely unchanged since 2008. Yet, inflation—the present but invisible enemy—has been steadily chipping away at the middle class. 

The real income for the average American household has declined in each of the past four years, resulting in a cumulative decline near 7%. Without coincidence, this happens to be the same period when the Federal Reserve embarked upon its unprecedented money printing experiment. 

The downside of monetary expansion is higher inflation. And a lower dollar means Americans will be forced to pay more for imported goods. What about the raw commodities that are priced in dollars like oil, grains and cotton? The value of the dollar would have to rise just to stay equal with what those goods are worth in foreign currencies. Eventually, higher inflation translates into higher interest rates. 

The reaction of certain commodities, particularly precious metals, has been astounding. 

Over the past five years, SPDR Gold Shares (GLD), which is linked to the price of gold bullion, has surged by 134%. Over that same period, the S&P 500 registered a loss of 4.10 percent. Does this mean advisors should back up the truck and overweight precious metals? Hardly! Rather, it emphasizes the importance of incorporating commodities exposure into a diversified portfolio mix of various asset classes. The end result is better, more stable performance returns.  

Another more diversified play on physical precious metals is the ETFS Physical Precious Metals Basket Shares (GLTR), which owns gold, silver, platinum, and palladium within the same shell. 

Other Assets

The Fed’s pledge to keep interest rates near zero until 2015 makes dividend income that much more valuable.

Aside from high yielding sectors like MLPs (AMLP), REITs (VNQ) and utilities (XLU), there are other routes to higher income but with less industry sector concentration.   

The ALPS Sector Dividend Dogs ETF (SDOG) applies the “Dogs of the Dow” theory to the S&P 500. The fund uses an equal weight methodology at both the sector and stock level. It caps 10% exposure to each sector and 2% exposure to each security. Unlike most dividend focused ETFs, it avoids over-concentration to high yielding sectors like financials and utilities. SDOG carries around a 5% yield and distributes dividends quarterly. The annual expense ratio is 0.40%. 

Finally, investing in defensive currencies is another way to hedge. Some advisors are investing in currencies whose central banks are least likely to push down the value of their own currencies versus the U.S. dollar. In this regard, the Mexican Peso (FXM) and the Canadian Dollar (FXC) have held up well. 

Protecting Assets

Yes, central bankers can lift the market. But the end game is less certain. What is the exit strategy for bankers? How do they stop stimulus without negatively impacting the market? How do they wean the market off its drugs?

Ultimately, the job of advisors is not just to manage wealth, but to find ways to protect it. We live in a stimulus- crazed world.

 
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