Market Overview

A Look Back at How Stocks Have Performed After QE

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The Federal Reserve announced yet another round of quantitative easing, or QE3 on Thursday. This time around, the Fed will be buying $40 billion in mortgage-backed securities per month on an open-ended basis. This third-round of quantitative easing will be smaller than both QE1 and QE2, but the structure of it will give the central bank considerable flexibility depending on what happens in the economy. The size and scope of the easing program could potentially expand if the economy remains sluggish.

The Fed said in a statement, "If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved."

In the wake of previous quantitative easing announcements by the Fed, the stock market response has been mixed. In early November 2008, the Federal Reserve began buying around $600 billion in mortgage-backed securities during the heart of the financial crisis. Prior to the crisis, the Fed's balance sheet consisted of roughly $700-800 billion of Treasury Notes.

As the first quantitative easing program wore on, however, that balance sheet ballooned to $1.75 trillion in various assets as of March 2009 and $2.1 trillion by June 2010, when the asset purchases stopped. Between November 2008 and the beginning of June 2010, the S&P 500 rose a little better than 12 percent. Investors who bought stocks as a result of the implementation of the first QE, however, had to endure some extremely steep losses in the near term as the S&P 500 plunged almost 30 percent between November 7, 2008 and the lows put in on March 6, 2009.

From there, the market moved steadily higher. When the asset purchases stopped in June 2010, the market retraced sharply until QE2 was announced in August 2010 at the Jackson Hole symposium. When QE2 was announced, the stock market staged another furious rally, rising steadily for months. Between August 27, 2010 (when Ben Bernanke indicated that QE2 was on the way in Jackson Hole) and April 27, 2010 (when Bernanke indicated that more easing was unlikely) the S&P 500 rose roughly 27 percent.

The program officially ended on June 30, by which time the stock market had fallen slightly from its earlier highs. The real effects of the end of QE2, it could be argued, were not felt until the end of July 2011 when the stock market went into a tailspin. Between July 22, 2011 and August 19, 2011 the S&P 500 plunged almost 15 percent, and the Dow Jones Industrial Average recorded a number of its worst days in history on a points basis.

Many market observers opined that the panic which hit the markets, was in large part driven by the end of QE2. Pervasive fear over the European debt crisis and the Standard & Poor's downgrade of the United States' AAA credit rating also helped to stoke market fears. Subsequently, the market strengthened once again, this time on better than expected corporate earnings and surprising economic strength.

Overall, recent quantitative easing programs have been a boon for risk assets over the near and medium-term, but investors have also had to endure significant volatility more often than not. This is something that stock investors should at least be aware of when making investment decisions in the wake of the Fed's announcement of QE3.

The Federal Reserve is hardly the only central bank around the world that has been flooding its economy with extra liquidity given sluggish growth and strained financial markets. The European Central Bank has also engaged in programs to help add liquidity to its markets.

This program has worked well in stabilizing the euro currency in the near-term and calming market jitters. U.S. and European stocks have both reacted positively to Europe's so-called "LTRO" programs which allow banks to borrow from the ECB.

Unfortunately, both the Fed's QE programs and Europe's LTROs are only temporary solutions. “While the liquidity provision helps keep tail risks for European banks at bay in the near term, as we have reiterated many times in the past, LTROs do not address the underlying solvency issues and ultimately funding stresses can quickly return,” says Nick Matthews, senior European economist at Royal Bank of Scotland.

Similar sentiments could be said about the near-constant quantitative easing programs in the United States. Money printing, on its own, is not going to turn the economy around and create sustainable job growth. It is a temporary solution, with very high risks, at best.

Posted-In: News Politics Psychology Events Global Economics Markets General Best of Benzinga

 

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