No QE3 Tomorrow - Replay Of 2011 Continues
As the days and weeks unfold the similarities to the summer of 2011 continue to unfold. In June 6th post "Forecasting The Rebound and Bottom" we stated then: "In each of the past two summers the market has experienced an initial very sharp decline which took the markets from extremely over bought to extremely over sold. This temporary washout allowed for a bounce back to previous resistance levels where investors, previously trapped into the decline, begin liquidating out of the market.
It was at this point that the markets retraced and set new lows as concerns over a weakening economy, the lack of liquidity and Eurozone crisis that continued to plague the markets. As stimulative programs were introduced in late summer and early fall the markets rallied and broke out of their respective downtrends."
It is this continued replay of the last two summers that have us on edge at the current time. The Eurozone crisis continues to brew with yields rising to dangerous levels for Spain and Italy. While Greece may have avoided a temporary crisis with the recent election there has been nothing done to address their solvency issues or rapidly deteriorating economy. Recession is dragging on in most of Europe and now has begun to deteriorate the economic strength of emerging markets and the U.S.
Interestingly, the continued calls for further support from the Federal Reserve have grown louder in recent weeks post the May decline. While the decline in the economic numbers has grown recently - the market has rallied fiercely as Wall Street salivates in anticipation of another "hit" of liquidity driven nirvana post the F.O.M.C. meeting tomorrow. History, however, tells us that this is likely not to be the case.
The chart shows the S&P 500 over the last three years with the summer events detailed more clearly. The markets, driven by stimulative actions of the Fed have peaked each summer just before the expiration of the programs. The market then experiences its initial decline, Point 1, as liquidity driven rallies are unwound as the economy and employment began to falter.
It is at this point that the calls for more stimulative actions are made by the media and Wall Street. The market then rallies on rumor and innuendo as expectations rise on hopes that the need for liquidity will soon be met - Point 2.
This is where we are today. Headlines, postings and tweets are filled with that hope of further accommodative action from the Fed. It is highly likely that the market will be disappointed for the reasons that we laid out in our recent missive "Inflation, Interest Rates and Dollar Open Door for QE". We said: "I do not think that we will see any action before the August-September period which we laid out in our recent PPI report. While there are many calls for Bernanke to announce QE at the June FOMC meeting, while possible, I think this is a fairly low probability event. Bernanke will likely wait to get a final read on first quarter GDP with some early diagnosis on 2nd quarter as well. With inflation taming, and the markets not absolutely collapsing at this point, my best guess is that he may hint at QE at the next meeting to gauge market response. As QE programs are highly inflationary he will likely wait until the end of summer, with a possibility of post election, to announce the next round of stimulative action. Make no mistake - there is no real organic growth occurring in the economy and no support coming from Washington. There will be further stimulative programs in the future — it is only a question of when."
That analysis remains salient today. The market is not that far off its recent highs. The economy, while slowing, is not falling off a cliff and the dollar is rallying while interest rates remain very subdued. For the Fed there is no impetus for launching a QE program at the current time — the market has priced in the bulk of whatever effect it may have had. Furthermore, as stated by Bernanke himself, the diminishing returns of each program are a concern and he will only want to launch further accommodative action only if absolutely necessary. That is not the case at this moment.
It is likely that the markets will be very disappointed tomorrow as Bernanke restates his position that he is aware of the weakness in employment, economy and Europe. He will also refocus attention on the current Administration stating that it is the job of Congress to act to create economic growth as the Fed's policy tools are not long term solutions. He will also reiterate his concern over the diminishing return of stimulative programs. However, he will leave the door open further stimulative action if necessary.
With the crisis in Europe brewing, yields rising, an upcoming election, weakening economics and a potential debt ceiling debate just around the corner it is very likely that we could see a slide in the markets into the August-September period. Each of the past two summers has played out very similarly and in both cases it was then that the Fed finally leapt into action. Will this summer play out exactly the same? It is all a guess. However, from an investment standpoint, the current level of downside risks grossly outweigh the odds of success.