Guest Post: QE3 - Just A Matter Of Time

Submitted by Lance Roberts of Streettalk Advisors

QE3 - Just A Matter Of Time

QE3 - Just A Matter Of Time

The 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 economy.

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.


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