Looking Beyond QE2

The post QE2 path for the economy and markets is becoming increasingly clear.  It was known from the beginning when the U.S. Federal Reserve’s launched its current $600 billion stimulus program late last year (widely known as “the second round of quantitative easing” or QE2) that it would come down to two possible outcomes in the end.

The ideal outcome:  Economic growth picks up and becomes strong enough to support asset prices inflated by Fed stimulus along the way including stocks and commodities.  In other words, the economy would eventually grow up to support higher markets.

The deficient outcome:  Economic growth remains sluggish despite Fed stimulus, placing inflated stock and commodities prices at risk for a meaningful pullback.  More simply, higher markets are left to fall back to the weak economy.

As we enter the final days before the end of QE2 on June 30, it is becoming increasingly clear that the deficient outcome will be the most likely.  Recent U.S. economic data has been disappointing to say the least.  Not only is the pace of growth sluggish at best, the economy is actually showing signs of slowing down with many readings coming in below expectations.  Beyond the U.S., the economic situation in Europe remains no better than it was a year ago at this time.  Instead, it is actually quite a bit worse.

With the deficient outcome most likely after QE2, what can we expect from markets?

First, stocks and commodities are likely to enjoy at least one more rally in the days leading up to the end of QE2 regardless of the fundamentals.  Today was another classic example of what we’ve seen throughout QE2.  Despite a day filled with lousy U.S. economic data, stocks rallied sharply higher on the news that Greece was set to receive another bailout and would avoid bankruptcy – for now.  No matter that Greece will simply be unable to repay its debts – they already can’t pay their current loans back, so lending them even more money isn’t going to solve the problem.  But while a market that can celebrate the can being kicked further down the road is certainly dubious, it does provide an ideal environment to gradually transition portfolios into the expected post QE2 winners.

So which categories are these expected winners.  They are listed below:

Likely post QE2 winners:
Selected Defensive U.S. Large Cap Growth Stocks
Selected Defensive U.S. Mid-Cap Growth Stocks
Investment Grade Corporate Bonds
High Yield Corporate Bonds
Non-Financial Preferred Stocks
U.S. Treasuries

This list comes with precedent – all of these categories either held steady or posted solid gains when the deficient outcome occurred after the end of QE1 last summer.  And many if not all are set up well to repeat this performance a second time around.

Of course, many market segments are likely to struggle under the deficient outcome.  The list of likely post QE2 losers are shown below (many of these have been winners in the current environment):

Likely post QE2 losers:
Most U.S. Stock categories – Cyclicals and Financials in particular
International Stocks
Emerging Market Stocks
Industrial Commodities – Copper, Oil, etc.
Agricultural Commodities
Financial Preferred Stocks
Non-US Sovereign Bonds
Emerging Market Bonds

What about the wild cards?  Preparing for the unexpected is critical, particularly in today’s markets.  While there are too many to mention in this e-mail, two particular events bear close watching in the coming months after QE2.  The first is the arrival of QE3 – just as they did last summer, the Fed could eventually step back in with another round of stimulus.  This would be a signal to potentially shift allocations back to the current “post QE2 loser” list.  The second is the situation in Europe – if things begin to really come apart in the Euro Zone, this would be a potential shock that could narrow and change the “post QE2 winner” list above quite a bit.  Stay tuned on both of these items – I’ll keep you updated.

The priority over the last several weeks and continuing in the coming weeks will be to gradually shift allocations away from the expected post QE2 losers and reallocate toward the anticipated post QE2 winners.  Closely monitoring the potential wild cards will also be important along the way.  Through it all, the focus remains on generating positive absolute returns, managing risk and seeking to capitalize on positive return opportunities regardless of the overall market environment.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met. 

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