Events around the world have certainly been unsettling for investment markets in recent weeks. Political unrest in the Middle East, ongoing sovereign debt concerns in Europe and the tragic humanitarian crisis in Japan are just a few of the many influences that drove the stock market down by over -7% since late February.
Given the ongoing uncertainties tied to many of these events, it is reasonable to consider whether this recent pullback represents the beginning of a more prolonged downturn in the stock market. The most likely answer – no, at least not yet.
The key factor has been driving investment markets over the last two years has been the unprecedentedly aggressive stimulus efforts from the U.S. Federal Reserve known as “Quantitative Easing” or “QE”. The Fed pumped $1.6 trillion in to the markets from March 2009 to April 2010 to rescue the economy from the financial crisis (QE1). And it stepped in with another $600 billion for markets starting in November 2010 to keep the economy from falling back into recession (QE2). As long as the Fed continues to pump stimulus into the system, investment markets including stocks are likely to have the support to hold their ground and resume moving higher, regardless of what happens politically or economically around the world. However, increasing market choppiness should be expected from here.
Through today, the Fed has deployed $332 billion under its current program and plans to distribute the remaining $268 billion by the end of June 2011. Therefore, we have a little over three months left before the Fed’s QE2 program comes to an end.
This leads to the key question. What will happen when QE2 is over at the end of June? An important clue is provided by what happened when the Fed ended QE1 back in April 2010. Immediately after the Fed stepped aside the first time around, the stock market plunged by -17% in just 10 weeks. And stocks would have likely fallen further had the Fed not stepped in starting in July 2010 with explicit signals that they would soon be implementing QE2 by Fall 2010.
Can we expect the same outcome at the end of QE2 in June 2011? The most likely answer – yes. The economy is simply not strong enough to fill the market void once the Fed stimulus goes away.
An important difference can be expected this time around – the market decline began literally as QE1 came to an end, but the market will now be anticipating this decline the second time around. As a result, we should expect stocks to begin to move lower at least a few weeks before the end of QE2 if not more.
So what’s the best way to position for the end of QE2? Many asset classes held up well and continued to rise following the end of QE1. These included TIPS, Investment Grade Corporate Bonds, High Yield Corporate Bonds and Gold. US Treasuries, the US Dollar and Volatility also rallied last summer after QE1 ended. An emphasis on these asset classes is likely to remain worthwhile the next time around. In addition, a focus on select high quality stocks, particularly in the Consumer Staples and Utilities sectors, was also rewarded after the end of QE1 and many of these stocks remain attractively valued today. I have been and will continue to shift investment strategies toward some of these categories and positions in the coming weeks and months as opportunities present themselves.
I will be checking back periodically with future commentaries on this topic as events unfold between now and the end of QE2 in June 2011.
Eric Parnell
Gerring Wealth Management
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