Looking Beyond QE2

The post QE2 path for the economy and markets is becoming increasingly clear.  It was known from the beginning when the U.S. Federal Reserve’s launched its current $600 billion stimulus program late last year (widely known as “the second round of quantitative easing” or QE2) that it would come down to two possible outcomes in the end.

The ideal outcome:  Economic growth picks up and becomes strong enough to support asset prices inflated by Fed stimulus along the way including stocks and commodities.  In other words, the economy would eventually grow up to support higher markets.

The deficient outcome:  Economic growth remains sluggish despite Fed stimulus, placing inflated stock and commodities prices at risk for a meaningful pullback.  More simply, higher markets are left to fall back to the weak economy.

As we enter the final days before the end of QE2 on June 30, it is becoming increasingly clear that the deficient outcome will be the most likely.  Recent U.S. economic data has been disappointing to say the least.  Not only is the pace of growth sluggish at best, the economy is actually showing signs of slowing down with many readings coming in below expectations.  Beyond the U.S., the economic situation in Europe remains no better than it was a year ago at this time.  Instead, it is actually quite a bit worse.

With the deficient outcome most likely after QE2, what can we expect from markets?

First, stocks and commodities are likely to enjoy at least one more rally in the days leading up to the end of QE2 regardless of the fundamentals.  Today was another classic example of what we’ve seen throughout QE2.  Despite a day filled with lousy U.S. economic data, stocks rallied sharply higher on the news that Greece was set to receive another bailout and would avoid bankruptcy - for now.  No matter that Greece will simply be unable to repay its debts - they already can’t pay their current loans back, so lending them even more money isn’t going to solve the problem.  But while a market that can celebrate the can being kicked further down the road is certainly dubious, it does provide an ideal environment to gradually transition portfolios into the expected post QE2 winners.

So which categories are these expected winners.  They are listed below:

Likely post QE2 winners:
Selected Defensive U.S. Large Cap Growth Stocks
Selected Defensive U.S. Mid-Cap Growth Stocks
Gold
Investment Grade Corporate Bonds
High Yield Corporate Bonds
Non-Financial Preferred Stocks
U.S. Treasuries

This list comes with precedent - all of these categories either held steady or posted solid gains when the deficient outcome occurred after the end of QE1 last summer.  And many if not all are set up well to repeat this performance a second time around.

Of course, many market segments are likely to struggle under the deficient outcome.  The list of likely post QE2 losers are shown below (many of these have been winners in the current environment):

Likely post QE2 losers:
Most U.S. Stock categories – Cyclicals and Financials in particular
International Stocks
Emerging Market Stocks
Industrial Commodities – Copper, Oil, etc.
Agricultural Commodities
Financial Preferred Stocks
Non-US Sovereign Bonds
Emerging Market Bonds

What about the wild cards?  Preparing for the unexpected is critical, particularly in today’s markets.  While there are too many to mention in this e-mail, two particular events bear close watching in the coming months after QE2.  The first is the arrival of QE3 – just as they did last summer, the Fed could eventually step back in with another round of stimulus.  This would be a signal to potentially shift allocations back to the current “post QE2 loser” list.  The second is the situation in Europe – if things begin to really come apart in the Euro Zone, this would be a potential shock that could narrow and change the “post QE2 winner” list above quite a bit.  Stay tuned on both of these items – I’ll keep you updated.

The priority over the last several weeks and continuing in the coming weeks will be to gradually shift allocations away from the expected post QE2 losers and reallocate toward the anticipated post QE2 winners.  Closely monitoring the potential wild cards will also be important along the way.  Through it all, the focus remains on generating positive absolute returns, managing risk and seeking to capitalize on positive return opportunities regardless of the overall market environment.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met. 

2011 Q2 Mid Quarter Update: Anticipating the End of QE2

Investment markets have pretty much followed the script so far in 2011 Q2.  Many of the risks that were hanging over the market at the beginning of April are still lingering.  The situation in the Middle East is far from resolved and the U.S. economic outlook remains muddled at best.  And some risks have risen to the next level.  Leading among these is the deteriorating situation in Europe.  Not only is the risk for default in places like Ireland and Portugal continuing to rise, but rumors even bubbled to the surface that Greece was threatening to leave the Euro Zone altogether.  But just as before, investment markets have continued to largely ignore these ongoing risks so far in Q2.  Instead, the focus remains almost exclusively on QE2, the Fed’s stimulus program that’s set to end on June 30.

Since QE2 is such a key driver for the markets, a few important questions are worth considering.  First, what can we expect from investment markets in the final weeks before the end of QE2 on June 30?  Second, how will investment markets react starting in early July once QE2 is finished?  Finally, what is the likelihood that the Fed will return with another round of stimulus (QE3) at some point later in the year?

To answer the first two questions, it’s worthwhile to examine the market by asset class:

Stocks – The steady rise in stocks that started with the launch of QE2 last year is becoming replaced by swinging volatility as we approach the end of QE2.  While stocks remain in an uptrend and reached a new post crisis high as recently as May 2, they are clearly losing steam.  Short-term corrections are also becoming more frequent and violent, suggesting a shift to the downside for stocks may soon be on its way.  Dissecting the stock market into its sector components is even more revealing.  When QE2 was launched last August, the more cyclical sectors including industrials, retailers and commodities were the market leaders.  But since the beginning of the second quarter, investors have fled these more economically sensitive areas in favor of more defensive sectors such as consumer staples, utilities and health care.  This type of sector rotation from cyclical to defensive sectors is also common during the late stages of a stock rally.  Portfolios benefitted from having a defensive stock emphasis heading into this shift, but many of these sectors are now starting to become a bit frothy in their own right.  As a result, individual stock selection will become increasingly important in generating returns and protecting against risk as we head into the post QE2 summer months, particularly if the broader stock market moves lower as expected.

High Yield Corporate Bonds – This “stocks-lite” asset class continues to post consistently strong performance.  High yield bonds have also avoided the swings of volatility that have been increasingly disrupting the stock market.  As mentioned in the past, companies that make up the high yield bond category are building cash reserves and paying down debt, which is positive for the sustainability of these upside returns going forward.  High yield bonds also remain reasonably valued and provide a +6% yield to go along with the steady price appreciation.  While high yield bonds are likely to experience a pullback to some degree following the end of QE2, they represent an ideal way to still maintain stock-like exposure in portfolios while also protecting against downside risk in what could be a turbulent summer for stocks.

Investment Grade Corporate Bonds – Put simply, investment grade corporate bonds are among the best investment choices in a post QE2 environment.  Most big companies are flush with cash and are ready to make the interest payments on their debts.  In addition, if the economy slows as expected once QE2 ends, investors will likely flock to the high quality yield provided by investment grade corporate bonds.  Although a bit overbought at the moment, investment grade corporate bonds valuations still remain reasonable, and the price performance of this asset class has also been consistently higher since the early days following the financial crisis, steadily rising both when QE is on and when QE is off.

Preferred Stocks – While this asset class should be generally avoided due to the near 90% weighting to financials, selected high yielding preferred stocks in the telecom and utilities sector may set up for attractive short-term investment opportunities in the coming months, particularly once we get into the post QE2 summer months.

Silver – The silver mania peaked and came to an end in Q2.  Portfolio gains were locked in near the peak of the silver market and downside volatility has become extreme in the aftermath.  While the thesis behind holding silver remains in tact, trading in this category has become toxic and remains overrun by speculators.  As a result, it is best to avoid the silver trade going forward and look for more stable opportunities elsewhere.

Gold – Unlike silver, gold continues to represent an attractive investment opportunity.  Chronic U.S. dollar weakening is a key driver behind the rising gold price, and this theme remains in tact with the U.S. government and the Fed still actively engaged in programs to promote money printing and currency debasement.  Secondary themes including the threat of a double dip recession and geopolitical instability in Europe and the Middle East also remain supportive of gold.  And the frequent talk in the press about gold being in a bubble is misguided, as trading activity in gold has instead been both rational and predictable for the last several years.  If anything, stocks are far more “bubbly” than gold at this point.  While short-term corrections like the pullback since the beginning of May should be expected along the way, the trend for gold remains very much in place.  The key level to watch for gold as we move through the post QE2 summer is the 150-day moving average, which is now at $1,404 per ounce but will continue to rise as we move through the summer.  As long as gold remains above its 150-day moving average – it is currently trading at $1,486 per ounce - the gold theme remains in tact.  On the other hand, if gold were to eventually break below it’s 150-day moving average on a sustained basis, it may then be the time to lock in gains.  Updates will follow along the way.

Treasuries – A variety of long-term risks face the U.S. Treasury market including massive fiscal deficits, declining demand from foreign lenders, ongoing political wrangling over raising the debt ceiling and the loss of a key buyer in the Fed once QE2 ends in June.  Despite these risks, Treasuries still have the potential to be an attractive short-term investment theme for the post QE2 markets.  The following are some key reasons.  First, the economy may show signs of slowing down post QE2.  Second, the situation in either Europe or the Middle East might take a turn for the worse.  Third, the U.S. government may finally make progress in getting its fiscal house back in order.  And finally, if the stock market falls into correction like it did after QE1, the trillions of QE2 dollars that poured into stocks will need to find a safe haven.  All of these forces would be positive for Treasuries and would not be unprecedented.  After all, many of these same forces helped drive Treasuries as the best performing asset class last summer – while stocks declined by over -15% from April 2010 to August 2010, long-term Treasuries gained +22%.  And the +8% rally in these same long-term Treasuries since early April 2011 suggests some are anticipating more of the same for the coming summer.  Any positions in Treasuries should be viewed as short-term holdings, however.

TIPS – Treasury Inflation Protected Securities (TIPS) perform particularly well when investors are concerned about inflation or deflation.  Recent worries over inflation have driven TIPS prices +8% higher since February, but they are currently overbought following this strong run.  The focus on inflation is likely to soon be replaced by the threat of a weakening economy, which is deflationary and would provide further support to TIPS.  Despite these advantages, many of the same risks that overhang the Treasury market are also risks for TIPS.  As a result, portfolio weightings to TIPS are likely to be reduced somewhat moving ahead.

Returning to the final question from the list above, it is very possible that the Fed may return later in the summer with talk about a new round of QE3 stimulus.  I would assign odds at better than 50% at this point given persistent global geopolitical instabilities and the fact that the U.S. economic recovery remains sluggish.  But the final result will depend on how the economy and markets perform in the aftermath of QE2.  Regardless of what form the Fed might deliver stimulus to the market, it would be reasonable to expect that this would spark yet another artificial rally in stocks and other higher risk markets.  How this all unfolds and the likelihood of QE3 will be the next key theme to watch as we move into the third quarter.

Bottom line – Investment markets are currently rotating in anticipation of the end of QE2.  The stock rally has lost steam and has become more defensive.  But many of the areas outside of stocks that are expected to perform well in a post QE2 environment have already begun to rally.  Advanced positioning in these areas has proven beneficial so far, but close attention to markets will continue be critical in the coming weeks as volatility is expected to increase further as we move past the end of QE2.  Fortunately, many investment categories remain set to perform well and provide opportunity in a post QE2 environment.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met. 

Agriculture Prices: Early Warning Signal

A key debate with QE2 ending in June is whether the economy can continue its recovery without government support.  If the pace of economic growth persists, higher risk assets such as cyclical stocks and commodities would likely continue to lead.  And if the economy stalls after QE2, lower risk assets such as defensive stocks and bonds would likely benefit.  In anticipating which result to expect, it is worthwhile to identify any leading indicators to the ultimate outcome.

In recent years, agriculture prices have provided a fairly reliable early warning signal, shifting roughly three months in advance of the stock market.  For example, while the stock market peaked in April 2010 after QE1 ended, agricultural prices had already crested three months earlier in January 2010.

Today, we see the same trend starting to take shape.  Agriculture prices peaked in early March 2011 and have been trending lower since.  However, stocks continue to rise.  If past precedence holds, the March top in agriculture prices would imply a peak for stocks in June 2011, which is also when QE2 is set to end.

The turn in agriculture prices is another signal that the broader stock rally may be nearing an end.  Thus, a portfolio shift away from economically sensitive cyclical and commodities stocks toward more defensive consumer staples and utilities stocks as well as bonds may be prudent.  These latter categories posted solid gains following the end of QE1 and have already begun to move higher ahead of the end of QE2.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Silver Exited on Friday

Silver corrected sharply today.  For the day, it was down over -13% at its lows intraday before ending the session down -10%.  But today’s outcome was not necessarily a surprise.  After rising over +160% since last August, silver has been in a full-blown mania.  Such manias are accompanied by increasingly volatility and usually end badly.  Recognizing these extreme risks in advance, all silver positions were sold last Friday, April 27.  The sale price was $47.87, which was near the recent price peak for silver and +12% above today’s close.

The underlying fundamental story behind owning silver - hard asset protection against aggressive monetary stimulus, inflation and currency debasement - remains in tact.  But the decision to sell silver last Friday was driven by several factors.

First, speculative activity in silver is becoming increasingly frothy.  Silver is a relatively small segment of the precious metals space and trading volume is typical a tiny fraction of what is seen in the broader stock market.  So when the trading volume of the iShares Silver Trust (SLV) exceeded that of the SPDR S&P 500 (SPY) last Wednesday with nearly 50% of all outstanding shares changing hands, this reconfirmed growing signs that far more that just fundamental investor conviction is at work in the silver market right now.

Second, after skyrocketing since last summer, silver had reached a critical resistance level in the $50 range.  This was the previous high from all the way back in 1980.  Silver made a run at $50 three times last week on Monday, Thursday and Friday and failed to break through this level in each instance.  This indicated that selling pressure was strong at $50 and would ultimately lead to a price pullback, as recent speculative entrants into the silver market eventually opt to exit the trade while the more aggressive speculators start to descend on silver with their bets that the price is going down.

Price swings are also becoming more violent.  Last Tuesday, silver plunged over -4% on options expiration.  The next day, it soared +7% following Bernanke’s speech.  And today it plunged -10%.  Such massive price swings are characteristic of what’s often seen at the ending stages of a mania, and the subsequent downside is typically sudden and sharp.

Finally, some qualitative indicators were also setting off alarms.  For example, silver is typically an investment that flies below the radar.  The mention of silver once a week on the mainstream business television channels would be a lot in a normal environment.  But in recent weeks, silver has been getting daily headline coverage on the major networks.  Such attention historically indicates that speculative buying activity is close to exhaustion, as the final marginal buyers are drawn into the market and selling demand begins to overwhelm buying demand.

While silver could continue to rise higher from here, risks are overwhelmingly to the downside from recent price peaks.  Now that the silver position has been exited, I will continue to monitor the market for any potential reentry points.  This will be unlikely in the near-term, at least until the speculative froth has been worked off, and any future positions would likely have a small allocation relative to past positions.  Instead, other asset classes currently offer better opportunities.  This includes gold, which has been behaving much more rationally with a much more predictable trading pattern.