With Stocks at Multi-Year Highs – QE3 May Be Overkill

The Federal Reserve is the most powerful financial institution in the world. It manipulates the world’s stock market seemingly at will, yet there are reasons to conclude QE3 is farther away than many expect.

Skunks are best known for their ability to spray a liquid with a strong, foul odor. The smell, a combination likened to rotten eggs, garlic, and burnt rubber, can be detected by the human nose up to a mile downwind. Smell aside, the spray can cause irritation and even temporary blindness.

The skunks reputation is well known, that’s why it roams around by day in the open and fears neither dog nor man. Skunks rarely ever have to use their “weapon” since just the threat of getting sprayed keeps predators at a safe distance.

The Fed, a unique financial animal, possesses a similar defense mechanism – it’s called QE .Like skunks, the Fed has established a reputation to use it when needed. This keeps “enemies” – such as market pessimists, realists, and particularly short sellers – at a safe distance. The Federal Reserve doesn’t necessarliy have to spray QE to get the effect of QE, just the threat is often enough.

Why Change a Winning Strategy?

Ben Bernanke is well aware of this fact. Essentially since the end of QE2 (June 2011), which resulted in a 20% stock market meltdown, Bernanke has been telling investors that the “Fed is ready to spray more QE when needed.” That’s been more than enough to keep stocks from collapsing. In fact, just the threat of spraying QE3 has lifted the S&P 500 Index (SPY) to a 51-month high and the Nasdaq-100 (QQQ) to a 12 1/2 year high.

Another animal analogy comes to mind. As long as you keep the carrot dangling the rabbit keeps running.

Why would Bernanke change a winning strategy (that of bluffing to spray or dangling the carrot) if stocks are already trading near multi-year highs? What, the economy is bad you say? The Fed’s past actions tell us that the economy may not be Bernanke’s primary concern. It seems easier to downplay millions of Americans being out of work than big losses of financial institutions on Wall Street.

QE Side Effects

Fortunately for the free market, there’s one asset class that keeps Bernanke and his inkjets honest. Oil. QE is inflationary. Like water in the bathtub that buoys rubber duckies along with all other toys, QE inflates the price of all assets (aside from those that have an inverse relationship).

Higher stock, gold, and silver prices are good for investors, but higher oil prices suffucate the economy. Oil around $110 a barrel coincided with stock market tops in April 2011 and March 2012. Oil at $85 in Apirl 2012 was enough to contribute to a 17% decline in the S&P 500.

With crude oil already trading near $100 a barrel, QE3 now or in the near future could be a double-edge sword with little net benefit for stocks and the economy (see chart below).

More About Skunks and QE

Skunks are reluctant to use their weapon, as they carry just enough of the chemical for five or six uses. The Fed has sprayed outright QE twice since 2008. This doesn’t include covert maneuvers like Operation Twist, currency swaps or low interest rates. How many more sprays of QE-like substances is the Federal Reserve good for? It seems to be running out of bullets.

Ironically, skunks have poor vision. This makes it harder for the stinky little mammal to decide who and when to spray. Bernanke’s “eye sight” (ability to foresee side effects of his actions) is similarly poor (click here for Bernanke’s bloopers). The Federal Reserve failed to see the 2008 financial debacle, or what’s been dubbed the “perfect storm,” brewing and has been playing catch up ever since.

An ounce of prevention is worth more than a pound of cure, but that’s a tough concept to grasp for a blind financial “animal” with a potent weapon.

 

 
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