What Happens When QE2 Ends?

By Josh Lipton Tomorrow, on March 9, the S&P 500 is scheduled to celebrate its second bull-market birthday. The historic rally has been dramatic and, for many strategists and analysts, unexpected. Two years ago, how many of your friends and neighbors would have bet that the US stock market would rocket up more than 90% after suffering a nearly 60% drubbing over a 17-month period? Investors have taken notice: there has been a clear upsurge in the amount of cash now making its way into stock mutual funds. Over the four weeks ending February 23, some $16.5 billion flowed into stock-market mutual funds, far outpacing the $6 billion that went into bonds funds, according to the Investment Company Institute.

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It's not just retail investors that feel more optimistic about the equity market, either. Their financial advisers are similarly much more upbeat. Charles Schwab recently released its ninth semi-annual survey of independent registered investment advisers (RIAs), which revealed a sharp increase in advisers' optimism since July 2010. More than three-quarters (77%) of advisers surveyed now expect the S&P 500 to rise in the next six months, up from 63% in the previous survey. More than half of advisers (56%) are bullish when it comes to stock market performance over the next six months, while only 10% see themselves as bears.

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The lack of hand-wringing is also evident in the Chicago Board Options Exchange's Volatility Index (VIX), otherwise known as the “fear gauge” as it tracks expected volatility in the stock market. The index is now just over 19 versus 53 in March 2009, meaning Mr Market appears a lot mellower these days. Still, other market participants feel less confident about whether this stock market rally can keep running to the upper right hand corner of the chart. Yes, corporate profits have enjoyed a remarkable rebound. Economic data has also been generally better-than-expected, with recent good news including upside surprises in US and global manufacturing and service data, auto sales, same-store sales, initial unemployment claims and private payroll data. However, a question some skeptics pose with increasing frequency is this: what happens in the investment markets if the Federal Reserve does not implement another round of radical monetary experimentation?

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Specifically, Federal Reserve Chairman Ben Bernanke and his allies on the FOMC reacted to the economic downturn by lowering short-term interest rates to near zero and also launching controversial bond-buying programs -- known as QE1 and QE2 -- to stimulate the economy and defend against the threat of deflation, or a persistent drop in consumer prices. Bernanke has remained very clear that he intended, with these extraordinary monetary actions, to drive investors back into risk assets such as stocks. He wrote about the issue in the Washington Post last November and even recently mentioned the rally in the Russell 2000 during an interview on CNBC. If investors see the value of their stock portfolios rise, so the thinking goes, then they will feel more confident and spend a little extra at the local mall. Business owners, pleased with a pickup in demand, will start hiring again. The stock market has certainly reacted to QE2 very favorably: since late August, when Bernanke first opened the door to another round of bond buying, the SPDR S&P 500 ETF (SPY), which includes holdings like ExxonMobil (XOM), Apple (AAPL), Microsoft (MSFT), IBM (IBM), and Bank of America (BAC) is up 23%. However, as the Treasury securities purchasing program draws to a close in June, some strategists worry about what happens next. The question becomes whether this rally fizzles once robbed of its aggressive public sector support.

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