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Craig Allen: Those Looking for a Fed Bailout via QE3 Are Facing Disappointment

Misinterpreting intervention can lead to missed opportunities in a fast-moving, and inevitable, market correction

Much has been discussed regarding a third round of quantitative easing, or QE3, in which the Federal Reserve would borrow and then use the proceeds to buy long-term bonds, driving rates down, bond prices higher and, in the process, flood the economy with even more cash.

Many (incorrectly) assume that the previous two rounds of quantitative easing have been undertaken as a direct response (by the Fed) to weak stock market performance. In fact, both previous rounds — QE1and QE2 — have taken place immediately following significant drops in stock market levels. However, Fed action with regard to QE has not been the direct result of stock market declines, but rather the economic turmoil that caused stock market declines. This is a very important distinction because, if we are trying to predict when and if the Fed will conduct a third round of QE, it would be incorrect and even dangerous to assume that if the stock market corrects to a certain level or percentage decline, the Fed will step in to address that correction with more QE.

The old adage that correlation does not equal causation is a critical and accurate description of the Fed’s previous QE operations. In other words, the Fed did not conduct quantitative easing because stocks corrected, but because of the economic factors that caused stocks to correct — namely the financial market collapse and disruptions of late 2008 and early 2009, and double-digit unemployment and negative growth of gross-domestic product growth coupled with real estate market foreclosures and other severe economic problems that we saw at the end of 2010. Falling stock prices did not motivate the Fed to conduct QE!

Now that the economy is showing signs of sustainable improvement, I do not believe that, should we see a correction in equities begin, the Fed will automatically step in with more quantitative easing. In fact, the minutes from the most recent Fed meeting specifically indicate that the Fed is not planning to conduct QE3, at least anytime soon, and only if the economy contracts significantly. Any belief to the contrary is nothing more than wishful thinking of overly optimistic market pundits searching for any justification to keep stocks moving higher regardless of the current, obviously over-bought market.

Investors would be wise to avoid falling into this mindset and accept the fact that stocks have rallied to unsustainable levels, at least in the short term, and are therefore due for a pull-back. Expectations of a Fed bailout to sustain the current, long-standing stock market rally naively assume that the Fed somehow cares about whether stock investors make short-term paper profits. I assure you that they do not.

The Fed is concerned with long-term, structural and fundamental trends in unemployment and GDP growth. The day-to-day, week-to-week and month-to-month gyrations in stocks are of very little concern to the Fed, and they are certainly not going to borrow additional billions of dollars more just to prevent stock investors from giving back paper gains they have attained over the past six months.

Keep in mind that if market pundits are at a point where they need to grasp at straws, meaning they’re depending on the Fed for QE3 to bail them out as their only chance of sustaining the current stock market rally, instead of valuations, earnings, economic growth, etc., anyone long in stocks should be very concerned! I personally like stocks for the long term, and feel they are the most attractive investment vehicle, in comparison to real estate, bonds, commodities, etc.

However, I feel very strongly that stocks are overdue for a significant correction, which is why I am holding very large cash positions at present. This coming week marks the beginning of earnings season, which looks to disappoint.  

We have had consistent earnings outperformance since the fourth quarter of 2008, which has contributed to the strength and longevity of the current stock market rally. For the first quarter since the end of 2008, we will have a weaker, disappointing quarter in which companies overall show slowing growth and many disappoint in terms of earnings projections. This, coupled with the weak jobs report for March — only 120,000 jobs added, far less than the more than 200,000 expected — should result in continued selling pressure on stocks.

A correction, therefore, is not only likely, it is a healthy component of any bull-market rally, and should come as no surprise to any seasoned investor. No market goes straight up or straight down, and the more investors try to fight the natural course of market dynamics, the more losses they will suffer. Savvy investors will understand that corrections are a natural and necessary part of any long-term advance for stocks, and will embrace this process.

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here for previous Craig Allen columns. Follow Craig on Twitter: @MPAMCraig.

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