QE2 Appears Fully Priced into Stocks

| January 7, 2011

The stock market is a discounting mechanism. It does not trade on the news and fundamentals of today. Rather, it looks ahead and trades on what it sees 3 to 6 months into the future. To quote William Peter Hamilton, editor of the Wall Street Journal during the 1920s and noteworthy Dow theorist, “the market does not trade upon what everybody knows, but upon what those with the best information can foresee.” Granted, the market may not always see clearly what is coming, but it always moves based upon what it sees. As we like to say, sometimes the market is right and sometimes it’s wrong, but it never loses an argument.

Following the cycle low in early September, stocks surged about 20% during the course of four months, driven in large part by the second round of quantitative easing from the Federal Reserve. When QE2 was announced, Chairman Bernanke stated in no uncertain terms that one of the goals of the program was to inflate stock prices and thereby engender a “virtuous cycle” based on the wealth effect. Many analysts lamented both the program and its stated objectives, although, reflecting upon the magnitude of the stock market gain since then, it would appear that the program was indeed successful.

However, it is always possible to significantly impact market valuations over the short-term, especially when an endless supply of liquidity is at your disposal. The real trick is to repair the underlying core damage that is currently weighing down the economy and preventing it from initiating the next structural growth cycle. The Federal Reserve can only do so much with smoke and mirrors, and until our historic public and private debt levels are meaningfully reduced, we will have no foundation for sustainable economic growth.

The QE2 program is currently slated to terminate two quarters from now. Given that stocks usually look forward about six months, it is likely that current valuations have already discounted the impact of the entire program. Granted, there is certainly nothing to prevent the Federal Reserve from engaging in QE3 (or 4 or 5 or…), but such hypotheticals are best left for future discussions. If we assume for the sake of argument that QE2 will mark the end of the Federal Reserve’s active inflation of stocks, they will subsequently require strong economic growth in order to continue moving higher in 2011, and the vast majority of market experts are predicting just that. For example, Goldman Sachs has forecast that the S&P 500 index will rally to 1,500 by the end of 2011 with GDP growing at an annual rate of 5%, earnings-per-share rising by 11% and PE ratios expanding by 8%. Let’s take another look at the S&P 500 monthly chart with that optimistic projection applied to it.

This is a typical consensus projection at the moment, reflecting the extreme level of bullish sentiment in the market. The prevalent view is now that economic growth will accelerate in 2011, propelling stocks up to their all-time highs. Looking at projected valuations, the current PE ratio of the S&P 500 index is 17.7, so an 8% expansion in multiples would result in an increase to more than 19 by the end of 2011, an extremely rich valuation that would exceed the peaks of 1929 and 1968 and forecast very poor expected investment returns for the foreseeable future. Even at current valuations, the Q Ratio indicates that stocks are at historically overvalued levels and both earnings and yield forecasting models predict S&P 500 total annual returns of only about 3.5% during the coming decade. Thus, even if the extremely optimistic consensus projections for 2011 prove to be on target, now remains one of the worst times in history to invest in stocks for the long run.

As for what to expect during the first half of 2011, again, stocks will require strong acceleration in real economic growth in order to sustain the cyclical uptrend from 2009. However, the next meaningful move will very likely be lower as the rally from September remains extremely overextended and our Sentiment Score is holding at the lowest level since late 2007.

The character of the next downtrend should provide a great deal of clarity with respect to long-term direction. If the next correction ultimately breaks below congestion support in the 1,120 to 1,130 range, the long-term topping scenario will reassert itself and a return to the June 2010 low will become likely. However, if the next downtrend holds above congestion support in the 1,150 area before returning to recent highs, a subsequent breakout and continuation of the cyclical uptrend will become likely.

Category: Commentary, Market Update


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