Has the magic of QE finally faded & should investors take defensive action?

In November 2008 the US Federal Reserve announced its first programme of Quantitative Easing which was dubbed “QE1”. Following the announcement the US stock market, represented by the S&P 500 index, rose by 37.5%. The US market also rallied strongly on the announcement of subsequent stimulus programmes, i.e. QE2 and Operation Twist.

Off the back of the first three stimulus programmes the S&P 500 rose by an average of 20.2%. However in the wake of the Fed’s announcement of QE3 on 13 September, the S&P has so far fallen by 1.7%. The question is, has the magic of QE finally faded and should investors take defensive action?

Below is a chart of the S&P 500 index which shows the announcements of QE1, QE2, Operation Twist and the Fed’s latest round of economic stimuli, QE3.

A 5 year chart of the S&P 500 index showing the Fed’s stimulus programmes (Click on the chart for a larger version)

A 5 year chart of the S&P 500 index showing the Fed’s stimulus programmes (Click on the chart for a larger version)

Chart courtesy of stockcharts.com

The S&P 500 index is generally considered to be the benchmark for the US stock market which is the largest most liquid equity market in the world.

QE timeline…

Quantitative Easing 1: On 25 November 2008 the US Federal Reserve announced that it would purchase up to $600 billion in agency mortgage-backed securities (MBS) and agency debt. On 1 December Fed Chairman Ben Bernanke gave a speech in which he provided further details, and on 16 December the program was formally launched by the Federal Open Market Committee (FOMC).

On 18 March 2009 the FOMC announced that the program would be expanded by an additional $750 billion in purchases of agency MBS and agency debt and $300 billion in purchases of Treasury securities.

Between 25 November 2008 and 31 March 2010 the S&P 500 rose by 37.5%.

Quantitative Easing 2: On 3 November 2010 the Fed announced that it would purchase $600 billion of longer dated treasuries, at a rate of $75bn per month. That program, known as “QE2″, concluded in June 2011.

Between 3 November 2010 and 30 June 2011 the S&P 500 rose by 10.6%.

Operation Twist: On 21 September 2011 The FOMC announced the implementation of Operation Twist, a plan to purchase $400 billion of bonds with maturities of 6 to 30 years and to sell bonds with maturities of less than 3 years, thereby extending the average maturity of the Fed’s portfolio of bonds.

On 20 June 2012 the FOMC announced that it would extend its Operation Twist programme by $267 billion, thereby extending it through to the end of 2012.

Between 21 September 2011 and 20 June 2012 the S&P 500 rose by 12.6%.

Quantitative Easing 3: On 13 September 2012 the Fed announced a third round of quantitative easing “QE3”. QE3 is an open-ended commitment to purchase $40 billion of agency mortgage-backed securities per month until the labor market improves “substantially”.

Since the announcement of QE3 the S&P 500 has fallen by 1.7%.

The bottom line

It is less than two months since the Fed announced QE3, it is therefore too early to conclude that the magic of QE has finally faded and that investors should take begin taking defensive action. The lack luster performance of the US stock market since the announcement does however warrant closer attention.

It may just be that QE3 was so well telegraphed thanks to the Fed’s new policy of openness that it was already priced into the market. It’s also possible, as we have said before, that the market is waiting for the outcome of the US presidential election. It’s is also possible that investors are fearful of the impending US fiscal cliff and are waiting for resolution their too.

However it is also possible that the market is beginning to price in a spell of deflation, in which case we can expect further falls. Those wanting to make a case for such as scenario could point to the fact that the money multiplier is at a 50-year low, or the fact that bank lending has not increased in any meaningful way. It is also worth noting that a lot of the liquidity that the Fed (and other central banks) are creating is simply being recycled back onto the Fed’s balance sheet in the form of excess reserves.

If a period of deflation does transpire it would surely be met with even greater stimulus, since deflation would be devastating for the US and other heavily indebted western nations.

Another possibility is that investors have finally realized that QE is no panacea for economic health. This would certainly help to explain the diminished response by the markets to each successive round of stimulus.

In any event, this is certainly a topic that we will continue to follow and report on.

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