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QEternity, the Federal Reserve Policy’s Implications

S&P 500 Long Term Trading Range

The stock market ran higher after the Fed’s announcement of its most recent monetary policy position. Prices were up largely due to Federal Reserve liquidity and the announcement that their Quantitative Easing policy, known as QE, will be extended with no known end date.

This QE program, which I am calling QEternity due to its not having a known stopping point, allows for the purchase of $40 billion of mortgage securities each month in order to continue to add liquidity to the US monetary system.

Several days prior to the Fed’s announcement, the European Central Bank announced a bond purchase plan to help boost the struggling European economies by providing liquidity to countries that were having trouble finding buyers of their debt. The world is awash in liquidity in the hope that it will generate some economic growth. Unfortunately, the economic headlines continue to give mixed signals for investors and businesses alike.

As we look toward year-end and into 2013, I am growing increasingly concerned with the level the S&P 500 has achieved. If you look at the graph above, you will see that we are approaching the top of the long-term trading range that we have been in during the current secular bear market. Given the current economic malaise in our country and in China, combined with the recessionary economies in Europe, I cannot see the S&P 500 starting a new secular bull market. I just do not see a catalyst to drive earnings significantly higher nor to entice investors to pay more for earnings.

The current P/E ratio for the S&P 500 is about 14, or roughly 10% below the historic average of 15.5. Investors are just not valuing corporate earnings to the same levels as they have in the past. Plus, earnings growth numbers for the companies in the S&P 500 on average have been decreasing over the past several quarters (please understand, this does not mean earnings are shrinking, only that the rate of growth is less than two years ago). In fact, today we saw several companies punished for lowering their earnings growth expectations: McDonalds, GE, Microsoft, and Google to name a few.

The Federal Reserve’s policy of printing money through Quantitative Easing (we’ve had the original QE, QE2, and Operation Twist preceding QEternity) has certainly pushed stock prices higher the past couple of years, but each iteration of that policy has had increasing less impact on the real economy. If you look at Japan which is on their eighth version of a QE program, their economy has been at stall-speed for a couple of decades with little permanent impact from QE related stimulus.

I just don’t see that this policy will drive economic growth in the US significantly higher – it should keep us out of recession but only provide for slow economic growth (maybe in the 1.5% GDP range) and it will likely have little impact on lowering unemployment. I also do not see it as a long-term stimulus to the cyclical stocks like we saw immediately after the Fed announcement – the cyclical stocks are perceived to be attractive when the economy is heating up, and we will likely be in a more slow-growth mode instead of in the midst of an economic flurry.

To start a new bull market in stocks and break out of the long-term trading range, we will need some sort of macro event or fiscal catalyst: the 1980’s had the Reagan tax reforms and the fall of communism; the 1990’s had the peace dividend, commercial use of the internet, and the Clinton balanced budget; and the 2000’s had the Bush tax cuts. These sorts of items have huge implications that stimulate the economy and provide for economic development and falling unemployment. Unfortunately, there aren’t really any of these caliber items on the horizon, so it is left to the Federal Reserve to keep enough liquidity in the system to facilitate the slow growth we have.

Does that mean we are headed for a Triple Top in this trading range? To have a new bull market start, we will need to break out above the top blue horizontal line and remain there on a sustained basis. That will take some sort of macro economic event or some major fiscal policy from Washington that fixes our economy, putting our economy on a much higher growth trajectory.

Because of the uncertainties ahead of us, we have been raising cash and getting more conservative in client portfolios. This means we have been using the post-QE rally to sell more volatile holdings, smaller capitalization holdings, and any holdings that we think might have profitability issues in coming months.

As we head into year-end and further into 2013, we will be focusing on companies with strong balance sheets, with low valuations compared to their growth prospects, and with shareholder friendly dividend policies. We believe that all of these attributes will be in favor – whether the company is large-cap or small-cap, foreign or domestic – and those companies should outperform other companies that are of lesser quality in a slow-growth economy like we anticipate.

Mark