Two Key Items in Any Post-QE Stock Market Response
Since stock market returns have been impacted by the Fed’s QE activities, it’s reasonable to assume that the market will return to more historical behavior if and when QE ends. So far, while taper discussions have resulted in down days for the market, these declines remain within a tight range. Moderate daily declines for the stock market with no outliers should not be expected. Traders should be prepared for stronger, more sustained declines when (and if) QE ends. See “The Bernanke Put” section below for more on this topic.
The second factor impacting what can be expected post-QE is much more difficult to pin down. In my opinion, the market structure that exists now with a reliance on volume from high frequency trading [HFT] with no actual liquidity responsibilities could pave the way to bigger one day or sustained declines. I simply believe market structure changes have coincided with QE and we’ll come out of this environment with something less familiar. Whether QE has provided beneficial conditions to HFT is left for another time.
I think more than ever retail traders need to have a plan to deal with more volatile conditions post-QE. In addition to identifying specific max loss amounts, traders need to be psychology prepared to manage exits quickly; fortunately technology can certainly help that process. Traders should also be prepared to monitor system performance (guidelines and rule-based) more regularly. Stellar systems under QE may be met with less favorable results and systems and strategies that have been shelved may need to have dust blown off them.
As a last thought on “what can be done” to prepare for conditions that may be months or years away (please, not years), be careful how you back-test systems. Include pre-QE periods and consider including a risk measure such as a Sortino ratio versus a Sharpe ratio. The former differentiates risk to the downside rather than all volatility for a Sharpe ratio. As option traders, many at Optionetics know that volatility can be good. Understand what the measure is telling you and what type of environment is best suited for a particular strategy or system.
So prepare for changes now even though the same stock market environment may persist, have a plan that identifies changing conditions and be prepared to adapt to changes if and when they occur.
Fed Activity, Objectives & Current Status
Since 2009 monetary easing efforts executed through the Fed’s Open Market Operations [OMO] has resulted in significant purchases in two primary product areas:
- Treasuries: Bonds, Notes and TIPS
- Agencies: MBS and non-MBS Agency issues
Objectives of the different efforts varied by program and included supporting the housing market and controlling yields across the shorter-term and longer-term ends of the yield curve. Its current activities represent a fifth round of intervention when including its initial extraordinary measures in 2009 and is referred to as QE3. As of July 17th total holdings in SOMA (System Open Market Account) were $3.25 trillion.
At the end of the article I include additional SOMA information and thoughts on where we are today.
As desired, the Fed has likely achieved its “wealth effect”. A shorter excerpt from Richard Fisher, the Dallas Fed Reserve President, summarizes this as follows:
That money—backed by an assurance that the FOMC will hold interest rates at zero and continue large-scale asset purchases for a prolonged period—should, theoretically, be put to use: a) by banks’ lending to consumers and to businesses that will expand employment, or b) by investors who, rediscounting valuations in the fixed-income and equity markets, will drive those markets higher in price, creating a “wealth effect.” This wealth effect should lead to further consumption as well as greater employment by businesses whose balance sheets have been reconfigured and enriched both by the cheapest leverage in American history and by booming prices for their stock.2
Since you can’t force banks to lend or people to borrow, I’m opting for higher stock market levels as an important objective for Fed policy. It seems keeping a stock market artificially elevated will eventually create fast and furious declines.
When a more favorable interest rate environment returns, it I very reasonable to speculate that money will move out of the stock market and into fixed income products, particularly in baby boomer investment accounts.
The Bernanke Put
When completing statistical analysis on daily returns for QE periods, the main thing that stuck out for me was the very narrow range of returns. Although both positive and negative returns were limited, you need to keep in mind that it’s the negative returns that are typically further from average returns. I think this gives new meaning to or perhaps concrete evidence of the “Bernanke put.”
Although the market doesn’t currently have a floor or lower strike price you’d equate with a put, narrow returns combined with a percentage of up days that were more than 10% greater than other periods (60.75% during QE versus 52.68% for all days) may create the same thing if we were to run enough trials to be statistically significant. Think about the Probability Cones in Platinum that map out price movement using constant volatility and mean returns at 0%; it seems we could identify a very reasonable floor using QE statistics and that lower blue curve that moves along the -2 standard deviation price move each day. It seems a more realistic QE floor would actually be within that 2 standard deviation band.
QE Digression with SOMA Detail
Figure 1 provides SOMA account values for all holdings as of April 2013 (valued at $2.97 trillion). As far as I understand, there is no cap on the dollar amount for SOMA and it’s certainly possible for additional trillions to be added to the account.
Data Source: Federal Reserve Bank of New York
Figure 1 SOMA MBS & Non-MBS Holdings (Jul 2003 – Apr 2013)
A distinction made by Fed Chairman Bernanke between credit the Fed’s monetary easing and what took place in Japan from 2001-2006 is that the Fed’s QE is targeted at specific securities to meet specific goals rather than pure balance sheet expansion.1 So US government debt is not actively being monetized, something deemed undesirable, it’s merely a side effect. It’s difficult not to include an opinion here on problems with this side-effect, but seems the right way to go.
One concern for me personally with this balance sheet expansion is the potential for people to simply lose faith in the Fed’s QE effectiveness resulting in markets with quickly rising interest rates. In addition to significant potential losses in SOMA, it seems the Fed could potentially return to extra-ordinary measures which primarily benefited the banks—companies in its own industry.
So regarding QE:
- Yes, we need a stable financial system and I welcomed initial measures that stabilized an out of control system. However, a bank that couldn’t survive past QE1 should not still exist in a free market economy.
- If the traction from QE2, Operation Twist and QE3 to date have not been sufficient to return us to sustainable growth driven by the private sector, perhaps we just need to experience another downturn to actually accomplish some of things a free market contraction is supposed to do.
A second major problem I have on the QE front is the damage done to those relying on reasonable fixed income returns. This includes savers and smaller banks not participating in the pre-meltdown windfalls. At what point do fiscally responsible entities get to benefit from an economy that is truly robust?
Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
Questions for Clare? Please visit the discussion board on the homepage of Optionetics.com.
1 Bernanke, Ben S. “The Crisis and the Policy Response.” London School of Economics, London, England. 13 Jan 2009. Stamp Lecture.
2 Fisher, Richard W. “Comments on Monetary Policy and ‘Too Big to Fail.’” Columbia University’s School of International and Public Affairs, New York, NY. 27 Feb 2013.