QE3 Misconceptions and How to Profit

The analysis of current Fed policy has included the usual parade of mistaken pundits.

There is a legitimate debate about QE3, but it has been obscured by those with an agenda based upon their politics or their business models.

The result is an exceptional opportunity for the long-term investor.

Mistakes

Here are the four biggest mistakes:

  1. It's all about me!  This is how the investment community views both the policy and every communication from the Fed.  What a blunder!  They look only at the effect on stocks.  The Fed mentions stock market effects, but only as one of several indicators.  They see the market as a confirmation that their moves either have helped the economy or are expected to do so.
  2. I don't understand the mechanism, so it must be wrong.  The typical pundit asks questions like the following:
    • Suppose a home-buyer does not qualify for a loan.  How will this change that?
    • Mr. Gundlach (or Gross or some other bond guy), How will this change your behavior?
    • How can this create jobs?  I don't see how to connect the dots.
  3. This is just printing money and monetizing the debt since the Fed is buying X% of new mortgages, etc.
  4. There is no exit strategy.  When the time comes to reverse course, we will have a disaster.

Reality

And here are the correct answers, pretty obvious to anyone with any training in economics:

  1. The basic objective is to change behavior on the part of borrowers and lenders.  The stock market is only one method for evaluating the impact and the "wealth" effect is only a minor transmission mechanism.
  2. The key to understanding QE3 is to think about marginal effects, not the all-or-nothing, "light-switch" thinking of those without economic education.  If you lower the price of something, it has a marginal effect.  Lower interest rates encourage more borrowers, qualify more borrowers, and increase the size of qualified loans.  The price changes affect (marginally) the interest rates on all related bonds.  The increased Fed balance sheet creates more excess reserves for banks and nudges them toward more lending.  Lower rates make business investments slightly more attractive.  This all takes place at the margin.  This is the incentive for risk that Bernanke talks about.  None of it has anything to do with pushing the average investor into risk assets, the popular pundit theme.
  3. The Fed is not monetizing debt if the purchases of securities are temporary.  The concept of "printing money" should relate to an increase in the money supply — M2 or MZM.  These increases have been modest — too low in fact.  The hyper-inflationistas have been wrong for a decade or so, but that does not stop their chorus.
  4. Reversing course depends upon the demand for US debt, both Treasuries and Agency securities.  Readers should note that those who have questioned this theme in the past, asking who will buy our debt at the end of prior QE's have been completely wrong.  I do not understand why Bill Gross could be so mistaken, but he was.  He does not seem to distinguish between the total volume of US Treasury trading and the net issuance.  Or maybe he has his own agenda.  Meanwhile, the average investor does not understand the total volume of Treasury trading.  (See this piece for an illustration).

Quantifying the Effects

There are some solid econometric efforts to quantify the QE3 effects.  Here is a Bloomberg article that is helpful by sharing some results:

"In a model-driven assessment based on the past impact of QE1 and QE2,
Deutsche Bank Securities chief economist Peter Hooper says this is what
the Federal Reserve printing another $800 billion — slightly less than
the gross domestic product of Australia — will do:

1. Reduce the 10-year Treasury yield by 51 bps

2. Raise the level of real GDP by 0.64%

3. Lower the unemployment rate by 0.32 percentage points

4. Increase house prices by 1.82%

5. Boost the S&P 500 by 3.06%, and

6. Raise inflation expectations by 0.25%"

 

I am disappointed that the writer diminished his helpfulness by skewing in such a skeptical direction about these findings, falling into the basic current trap of catering to his audience.

The Deutsche Bank conclusion is correct.  The general direction and order of magnitude of these effects makes sense given past QE policies.

A Deeper Look

In fact, I expect the current QE round to be more effective than the past versions.  Why?  The focus on changing expectations.

In the past, any good economic news was greeted with the notion that the Fed would step back.  The current policy changes this.  The Fed is committed to economic stimulation, even if it pushes inflation somewhat above the 2% target level.

For those who don't like the the Fed inflation measurement methods, you can just multiply by ten or apply whatever other silly adjustment you think is right.  Meanwhile — learn to live with it!  This is the new policy.

Investment Implications

The basic conclusion is that the business cycle is going to be extended significantly.  We are in the third inning or so.  It is a good time for tech stocks and deep cyclicals.  (I like and own CAT, ITW, AAPL, ORCL, and INTC).

Financial stocks will enjoy a nice yield spread.  Europe will be helped.  (Think GS, JPM, AFL).

The timing is a bit different from past QE's.  Since everyone is busy misinterpreting the policy, bashing the Fed, and politicizing the decision, the immediate market impact has been muted.

This time the real test will come via the actual economy, not the speculative commodity buying of the those with a simplistic view of Fed policy.  The upside catalyst will come when we see some stronger economic reports, as we did with yesterday's ISM numbers.

 

 

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10 comments

  • fresh October 3, 2012  

    I would disagree with “fed is not trying to push people into risky assets”. Their is no yield anywhere.
    Municipal bonds are getting promoted at every level, media, government, legislative (make FA’s not liable for recommending munis).
    Sure they are trying to get people to move money into anything.

  • Pacioli October 3, 2012  

    OldProf –
    I definitely agree that pervasive, disastrous misunderstandings abound regarding what QE is and what it is not. I agree that the term “money printing” is erroneous, agenda-driven, and a completely inaccurate way of describing the mechanics involved. And your point regarding the scale of QE in the context of total Treasury volume is very well taken.
    However, I think the “how to profit” component of your entry is sorely lacking. Below are the returns of the recommendations you cite specifically, from the closing price the day before the QE3 announcement, through yesterday’s closing price.
    CAT -4.1%
    ITW -3.7%
    AFL -2.0%
    ORCL -1.9%
    INTC -1.5%
    AAPL -1.3%
    GS -0.8%
    IEV -0.5% (proxy for Europe – ‘Europe will be helped’)
    JPM 2.5%
    So, all names are down except for JPM. Meanwhile the S&P is flat, and long-term US Treasuries (TLT) are up 1.8%.
    I recognize that you did attach the caveat that “the business cycle is going to be extended”. But I think that that characterization is just a euphemism for the reality that this recovery is going to be exceedingly weak for an extended period due to the massive scale of private sector debt deleveraging that must transpire following the prodigious imbalances that were allowed to persist through 2007-2008.
    Despite my disappointment with your “how to profit” component, I do agree that the widespread Fed bashing is severely misguided. Fed policy will never be enough to affect anything other than marginal dimensions. They are doing what they can, but there is so much that is completely out of their control.

  • oldprof October 3, 2012  

    Pacioli — If there were no misconceptions, the stocks I named would have rallied:) That is the point.
    The trading world uses very simplistic rules, expecting an immediate effect from a QE announcement. That is why you see the pundit parade announcing that it “didn’t work.”
    Time will tell. And I generally agree with your interpretation of a weak and extended recovery. I think that corporate profits will do fine.
    Thanks for joining in — interesting points.
    Jeff

  • The_Dumb_Money October 3, 2012  

    Thanks as always for your perspective. A great many financial advisors, most of whom are CFAs but do not have economics degrees, have highly innacurate and ideological perspectives on the Fed.

  • @vladkeynes October 4, 2012  

    Misconceptions… thats the key, since I do not believe “model driven assesment on the past qes” included any irrational behavioural concepts on the part of investors, or any subjective probabilities at all. Models will work only within certain constraints and assumptions; real world is another thing we should really come back to Keyness’ work on uncertainty – he did some extensive work with probabilities. Meanwhile please see this article ( http://www.economist.com/blogs/freeexchange/2012/10/monetary-policy?fsrc=gn_ep), as it sheds light on who can and will really profit from the FEDs policy

  • Pacioli October 4, 2012  

    I thought this was relevant and timely.
    http://bit.ly/Vi3woz
    This writer has been well reasoned in his recent discussions regarding QE.

  • oldprof October 4, 2012  

    Pacioli — This is an interesting article which also cites a number of excellent sources.
    Thanks for the link!
    Jeff

  • oldprof October 4, 2012  

    Dumb Money — I agree with your assessment, and it is sad. To be a good advisor you need to separate your own views from your market forecast.
    Jeff

  • Heat Rate October 4, 2012  

    Jeff – what was your performance between 2007 and March of 2009? Stocks climbed a wall of worry then too? Same with 2001 to 2003?
    At some point reality sets in.

  • oldprof October 4, 2012  

    Heat Rate — Those of us who do not have a mutual fund are not allowed to advertise performance. Try checking Doug or Barry, for example, and you will see the same thing.
    In the first place, I have six different programs, and the performance varies by program.
    The longest program I have (ten years) is normally fully invested, but actively managed. It has a great long-term record which I am happy to share fully with investors who make inquiries.
    I did really well in 1998 (despite the crisis then which you omitted), and also in the 2001-03 period. I also did well around both Gulf wars. I am always working to improve methods.
    Regular readers know that my investment posture shifts regularly reflecting a number of factors. Last October, for example, I became more conservative for most accounts because of risk.
    My most popular program right now is the enhanced yield approach — dividend stocks with short-term covered calls (and the short-term is the key).
    If you do not understand the wall of worry concept, you are essentially doomed as an individual investor. You will get the market timing wrong not just once, but every time. That is why the average person loses 4-8% to the market every year while the pros are beating it.
    If you are a legitimate investor, please give me a call and I will be happy to discuss your individual needs, and which program might work for you!
    And thanks for giving me a chance to highlight some important points!
    Jeff