Guest Post: QE3 - Just A Matter Of Time

Tyler Durden's picture

Submitted by Lance Roberts of Streettalk Advisors

QE3 - Just A Matter Of Time

QE3 - Just A Matter Of Time

media has been replete lately with a variety of different government
officials saying that there will not be a third round of Quantitative
Easing.  Even the great Ben Bernanke himself on April 27th spoke against
the possibility of QE 3.  This isn't surprising, of course, because in
order for something like QE to have the most effect it needs to be,
well, a surprise.

However, I am throwing down the gauntlet and making the call - there
will be Quantitative Easing, and a big one most likely, by the end of
summer.  There I said it; of course, I have actually been saying this
for the last couple of months and it doesn't take much of a real genius
to figure it out considering that we are heading into a presidential
election year.  However, it most likely won't be called QE 3 since the
term QE is now politically and socially almost taboo.

The Whitehouse Effect

So why does QE play such an important role for Obama going into an
election?   No president has ever been reelected to office when
unemployment is above 8%, much less 9%.   With the unemployed labor pool
at very high levels, poor sales being the biggest concern for small
business owners (according to the most recent NFIB survey) and wages
failing to keep up with a rising cost of living there is no incremental
demand on businesses to create new jobs.    Since small businesses have 6
applicants for every 1 job opening, are are the primary creators of 70%
of the jobs in the country, there is no pressure for wage increases.  
Without rising incremental demand from consumers, because 1 in 5 are
underwater or delinquent on their mortgage, are unemployed or on food
stamps, there is no reason for small business to expand production or
manufacturing.   While the Federal Reserve has been worried lately about
commodity price inflation - the real threat to the economy is wage
deflation as it bites into the basic economic cycle of a supply/demand

However, it isn't just the unemployed that will kill Obama at the
polls.   Without another round of QE, and most likely soon, the economy
will be headed for extremely low or potentially even negative growth.  
When round one of QE finished in the summer of 2010 the economy slid
form 3.1% annualized growth to 1.7%.    This shock to the system
immediately launched the Fed into overdrive to start QE 2.    Today we
are heading into the summer with a 1.8% annualized growth rate, likely
to be revised down a notch, and as QE 2 winds up entirely at the end of
June we are likely to see a slide to below 1%.   This will most likely
get a very late night phone call placed to Mr. Bernanke from the
Whitehouse as the average American votes psychological and emotionally. 

In the last election the average American overwhelmingly voted an
inexperienced and unproven individual with great oratory skills and
personality into the highest office in the country on the back of a
Pepsi slogan - "Hope and Change".    Unfortunately today, 70% of the
population, according to a recent Gallop poll, have lost the "Hope" part
of the equation as they still "feel" like we are in a recession or
depression.    That's right, they "feel" like things are not good which
is an emotional bias; and they will vote the same way.

Furthermore, as the economy slides, so does the stock market as
prices are adjusted to reflect what the future profitability of
companies may look like.   With the market currently expensively valued
and analysts still predicting higher profit margins in the coming months
- anything that creates stress on corporate profitability, like a
weakening economy, will cause a correction in asset prices to reflect
new estimations.    As always, the market, because it is driven by human
psychology (fear and greed) in the short term will overshoot on the
upside as well as on the downside.   Therefore, another nail in Obama's
reelection coffin will be if the stock market has declined by 20% going
into campaign mode.   Remember, it was just earlier this year during his
State of the Union address that he specifically stated that under his
watch the economy had recovered along with the stock market.   People
are emotionally affected by the value of the stock market - the "wealth
effect" is a driver of consumer behavior.   When Ben Bernanke launched
QE 2 he even added a third mandate to the Fed to include not only full
employment and price stability but also asset inflation to create a
wealth effect.   Without that wealth effect going into the polls -
voters are very likely to pull the lever for "Change".

How To Play It

Beginning back on April 25th we began writing about reducing
allocations to risk based assets (read: equities and commodities) going
into the summer months and the end of QE 2.   As shown in the chart when
QE 1 ended last year there was a fairly substantial decline in the
markets of almost 20% as the economy began to slow down.   Having only
that precedent to work off of we should remain cautious and reduce
allocations of invested dollars in all risk based categories rather than
rotate sectors.    I say this because rotating from Technology to
Utilities may provide outperformance in the portfolio - during a market
correction it will only mean that you will lose less money.   Moving
into cash and fixed income for the summer months as QE ends has yielded a
net positive return to date.

Furthermore, this strategy now sets up the individual investor for
part two of the strategy which is having dry powder available to buy
back into equity exposure when QE 3 is announced.   The market has now
been trained, like Pavlov's dogs, to respond to the QE call.    When Ben
Bernanke and friends ring the dinner bell the dogs will come running
and having cash on the sidelines protected from the summer sell off
certainly provides an opportunity to be the "strong hand" buying from
"weak hands" at that point.  

Remember, being cautious is more important than losing money.   The
media is constantly telling people to chase stocks which have been one
of the, if not the, poorest performing asset class over the last
decade.   You can always make up a lost opportunity - it is nearly
impossible to make up lost capital.

How Much And When?

So, now we know that the Whitehouse needs QE 3 the most right now but
how big might it be.   QE 1 was $1.25 Trillion coming off the lows of
the market in 2009.   QE 2 was $600 Billion in the 3rd quarter of 2010
but really had very little effect relative to the effects received from
QE 1.   I have spoken in the past about the "Diminishing Return"
syndrome that would come with each successive QE program.   In order for
QE to have any real "bang for the buck" this time around it will have
to be big, really big, like $2 Trillion in total.    However, not only
that, but it will also prove ineffective unless it is combined with a
serious attempt at mortgage equity write downs, which will have to be
combined with guarantees for the second lien holders, mortgage fraud
forgiveness for the banks, further tax cuts and credits for small
businesses and some real regulation for the banking industry to restore
faith in the stability of the financial system.    (As a side note -
I am really against bailing out homeowners and banks as it is a process
fraught with peril and another article for another day.)

This is what it will take to kick start the markets again and boost
asset prices, jolt the economy back to 2.5% growth and keep the big "O"
in office for another four years - maybe, and that is a big maybe at
this point.   It will also just "kick the can" down the street for
another brief period in time until we all realize that we are in a
balance sheet recession and until the total amount of debt, which the
majority of it belongs to households, is reduced to a sustainable level,
savings rise to historical levels which can sustain growth and the
consumer is able to start creating the incremental demand needed for
businesses to grow - we are going to be stuck in this cycle for quite a
long and frustrating time.