What’s behind the rally in stock prices since mid-summer?  It sure hasn’t been the global economic data or earnings outlook, which have continued to drift lower.  The real impetus has been the fact that central banks almost everywhere have ‘opened the spigots’ of monetary easing fully, particularly in the U.S. and Europe.  After providing major monetary stimulus to financial markets over the past four years, U.S. Federal Reserve Chairman, “Helicopter Ben” Bernanke has pulled out all the stops and gone to his most aggressive monetary stimulus program, referred to as QE3 (3rd round of quantitative easing), but which is really “Unlimited QE.”  Stock markets have responded favourably with global stocks rallying sharply both on that news as well as the almost simultaneous moves by the ECB (European Central Bank) to engage in a similar program of buying bonds to push long-term interest rates lower and stimulate growth in the global economy.  With the Fed’s announcement and the ECB declaration of unlimited bond purchases, we have entered a new phase of central bank intervention – perpetual easing. In a sense this is simply a return to a prezero-bound world – central bankers will step in with support when the economy slows. It used to be rate cuts, now it is asset purchases. However, there is now a clearly stated goal of pushing investors into risk assets. If the few years are any guide, regardless of the impact of this latest round of easing on the real economy, markets are likely to continue moving higher with leadership coming from cyclical, value and risk stocks.

If the additional liquidity from QE3 is able to stimulate the global economy, as it has in the past, companies with high foreign exposure will be favored over those with low foreign exposure.  Stocks in cyclical/resource sectors of the market typically have higher foreign exposure than the more defensive sectors.  Many of the sectors with high foreign exposure are also heavily concentrated in sectors consistent with a “risk-on” atmosphere.  This fits in well with our current investment strategy which is to be about 20% overweight stocks within balanced portfolios, with a focus on the Basic Materials, Energy, Industrials and Technology sectors.  We have seen some strong moves back into the cyclical stocks lately, with the junior resource category seeing the biggest bounce.  Those stocks were pummelled in the prior 18 months on global slowdown fears and risk aversion.  But increased corporate activity in the junior golds in particular seems to be drawing investment funds back into those stocks.  Technical stock market conditions also appear to have bounced back through key support levels, driven by the strong results following recent other periods of central bank intervention.

The chart below shows how this has worked in the past.  Looking at the performance of financial markets 3 months prior to and after similar stimulus programs in the past, we can see a reversal of performance in the more ‘ risk-oriented’ investment categories including small cap stocks, cyclical stocks, value stocks and European stocks versus the S&P500 in the U.S.   As an example, small cap stocks had under-performed larger stocks by 1.7% in the 3 months prior to intervention but then out-performed large stocks by 4.1% in the subsequent 3 months.  The most dramatic appears to be the Stoxx 50 (a composite of 50 of Europe’s largest companies from 12 Euro-Zone countries) over the S&P500 in the U.S., where the Stoxx 50 did 13.2% better in the 3 months following intervention.  We have seen similar moves already following the most recent announcements from the U.S. Fed and the ECB.

Fed QE3 Improves 'Risk-On' Trades

While there seems to be little argument about the shorter-term benefits of central bank intervention for financial markets, the problem seems to be in the longer-term impact.  The unprecedented amount of monetary stimulus has often been referred to as ‘financial heroin’ in terms of its impact on financial markets.  The results are too short-lived and there is the risk of higher inflation levels as debt piles up.  To sustain the stock market gains and improve on them in the longer-term, we need to see an improvement in global economic conditions.  While the optimists point out that the ‘sugar high’ from QE programs increases global wealth, there seems to be less support to the premise that these programs actually impact spending levels and long-term economic growth.  In order for stock markets to move significantly higher we need to see some more evidence that the global economy has truly emerged from the 2008 downturn.

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