News Analysis date published New: 
Thursday, February 16, 2012 - 13:00
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Thursday, February 16, 2012 - 13:18
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Thursday, February 16, 2012 - 13:00

Are We Headed for QE3? How to Protect Yourself (and Profit)

Thursday, February 16, 2012 1:00 PM

The U.S. economy has seemingly turned the corner, thanks to a string of positive reports since the start of the year. Yet a surprising number of economists simply aren't buying it.

[block:block=16]Their concerns include:
A belief that economic reports have been skewed by an unusually mild winter.
The recent spike in consumer borrowing is unsustainable and will need to reverse course.
The economic problems in Europe will still wash up on our shores.
Much of the recent strength in the industrial segment of the economy is due to inventory rebuilding, and inventories are now back to normal levels, eliminating the need for any further inventory stocking.

These economists anticipate a downtick in the tone of upcoming economic reports, which would raise fresh concerns at the Federal Reserve that the economy still needs a boost. Unsurprisingly, these folks have begun speaking about QE3, or a third round of Quantitative Easing, the set of monetary measures conducted by the Federal Reserve to stimulate the economy. (Here's a handy primer on quantitative easing.)

If events play out as these economists suspect, then investors have reason to be bearish in the very near-term, but bullish in the intermediate term. Any action by the Fed, perhaps as soon as the late April FOMC (Federal Reserve Open Market Committee) meeting, would likely help fuel a rebound in stocks.

If history is any guide, then the next round of quantitative easing should help pour liquidity into the market, which in turn would help ignite a range of asset classes. During the most recent round of QE, or QE2, gold, stocks and commodities fared well, as you can see in the chart below.

To boost the economy under the QE2 program, Fed Chairman Ben Bernanke used the bank's balance sheet to buy roughly $600 billion worth of bonds. The move had the equivalent effect of lowering interest rates by 100 basis points (or 1%), which the Fed could not do directly because rates were already near zero and would become negative.

Economists say QE3 would be of a similar size -- around $600 billion -- though this time around they expect the Fed to focus on mortgage bonds in hopes that the move would push down mortgage interest rates, providing another catalyst to the beleaguered housing market. In my personal view, that's not really necessary, because potential home buyers are hardly fretting over mortgage loan rates right now since a 30-year mortgage already hovers around 4%. The difference between a 3% mortgage and a 4% mortgage is almost inconsequential for most potential home buyers.

Still, the holders of those $600 billion in mortgage bonds would need to redeploy their funds into other investments, which is why many other asset classes are expected to get a boost.

A fairly clear beneficiary would be gold. Not only would gold benefit from the extra liquidity sloshing around the market in search of somewhere to go after mortgage-focused funds have been freed up, but inflation hawks would be further convinced that the Fed is embarking on a risky path of inviting potentially higher inflation down the road. Indeed, all of the liquidity doled out in QE1 and QE2 is still circulating, and the bank would need to show a deft hand when it comes time to sop up all this liquidity.

We're talking about well more than $2 trillion in this stimulative funding ($1.3 trillion for QE1 and $600 billion each for QE2 and QE3) which, according to gold bugs, would create a bubble when the economy gets truly healthy. Here's what happened to gold prices during QE2, using the same time frame as the chart above.

I'm not a fan of the gold angle because the entire "runaway inflation" scenario is a bit too speculative for me, but many gold-focused investors are likely to react to QE3 as they did to QE2.

Small-cap stocks have done quite well so far this year, because investors are moving out on the risk curve. These stocks would also likely see even more buying if investors keep lightening their formerly-high exposure to the safe blue-chip stocks. But small-cap stocks also bring a cautionary note to the QE3 game plan. During QE2, investors started to shed exposure to small caps when they sensed QE2 would soon be ending, as the chart of the Russell 2000 shows.

So if the market gets a solid boost from QE3, then don't stay at the party too long. Booking profits in any strong gainers is always a wise move whenever stocks are rallying for external reasons such as machinations from the Fed.

The best-positioned sector
There is one sector that would get a clear long-term boost. To understand the play, let me pass on an analogy. If QE1 and QE2 were to jumpstart to a dead battery, then QE3 is a battery charger that helps top-off the battery so it doesn't die again. In effect, the Fed wants to nudge the economy from the current period of intermittent growth onto a sustainable and more robust growth plane.

This would be great news for banks.

I've noted bank stocks are very inexpensive and now carry less risk than before. But banks stocks will only flourish when the economy is showing real vigor. That's what the Fed hopes to achieve, and no sector is more levered to rising economic activity than the banks. Citigroup (NYSE: C), which is a member of my $100,000 Real-Money Portfolio, remains a favorite pick, but QE3 holds the potential to boost the whole banking sector.

Risks to Consider: If the economy continues to show signs of strength, then the Fed may decide to postpone or cancel QE3. And in the absence of such stimulus, stocks could be hit by profit-taking with a commensurate rebound that QE3 would have given.

Action to Take --> If the economy indeed cools off in coming weeks and months, then stocks would surely see some profit-taking. If this happens, then analysts at Societe General (SocGen) have suggested a clear game plan: "We would use this significant correction to increase weightings on risk assets ahead of QE3."

This implies underperformance of the safest investments such as utility stocks, and potential outperformance of more volatile asset classes such as commodities, small-cap stocks and other high-beta stocks such as tech stocks or stocks with high price-to-earnings ratios.

[Note: You can follow along with my $100,000 Real-Money Portfolio trades free for a limited time. Simply click on this link to sign up.]

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of C in one or more of its “real money” portfolios.