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The End of QE


In spite of the Federal Reserve’s forewarning weeks ago that they were planning to end their bond buying monetary stimulus activity known as Quantitative Easing (QE), when they formally ended it today the stock market sold off.

If you look at the graph above, you can see the big swoon down at 2pm when it was announced. The market then fretted for a bit and the buy-the-dippers came in and pushed the market back up to almost break-even on the day.

What does it all mean? The QE activity was a way for the Federal Reserve to increase the money in circulation by buying government bonds from the Wall Street banks and crediting them with the payment for the bonds using newly created money.

This new money was supposed to do two things: (1) provide liquidity for banks to increase credit to stimulate the economy; and (2) generate a wealth effect by increasing the value of the stock market. They certainly accomplished point two but it doesn’t seem that they were able to accomplish point one.

Now that this newly created money will not be a stimulus to the investment markets, the stock market will have to move higher the old fashioned way – based upon earnings growth and a sound economy.

Tomorrow’s announcement of 3rd quarter GDP will be the first major economic announcement and stock market investors will be paying close attention to it. A solid number will ease their minds and allow the market to move higher – a weak number will have the opposite impact.

It will be interesting if we start to see a rotation out of the top 50 largest companies in the S&P 500 (these are the stocks that have seem the most buying interest during the QE cycle as they are also the most liquid and easiest to accumulate) and into small cap/mid cap and the smaller blue chips.

Traditionally, earnings growth in these companies has been higher than in the top 50 companies and earnings growth is rewarded by investors with P/E expansion and higher stock prices. If so, then the beta driven market we have seem the past few years will revert to an alpha driven market and reward investors who do their homework accordingly.

In a beta driven market, index funds are the winners because money flows into the largest companies simply because they are the largest companies. In an alpha driven market, money flows into the companies with the best investment fundamentals.

Our core investment methodology is an earnings growth-based analysis. I for one welcome this as fundamentals like earnings and valuation will matter again and investors will see the benefits of active portfolio management.

For index fund investors and portfolio managers that have benefited from mimicking the index holdings over the past few years, this is the end of the world as they know – but I feel fine.