Just Because The Fed May Ease, Doesn't Mean You Should Buy the Market

Yesterday's announcement from the Federal Reserve was probably as dovish as it could possibly get without actually announcing some new plan with a four letter acronym.  Basically, the economy is rolling over, inflation is easing and they are prepared to act as more information comes in.  After some indecision, and a couple of false starts (many people actually expected the third round of quantitative easing, nicknamed QE3, to be announced) the S&P 500 went up by 4.7% on the day.

So the question is, once the Federal Reserve does start easing, should you buy stocks?  Not necessarily.  A lot of people like using the phrase "Don't Fight the Fed", as if it's a losers game to go against the well informed junta sitting on top of unlimited gobs of cash.  That totally makes sense, but unfortunately if you followed it ahead of the last two recessions, you would have lost quite a bit of money.  The problem is that, the Federal Reserve only eases when things get bad, and you never know how bad things are until later, so the market can still go to heck, even with Fed action.  On January 3, 2001, the Federal Reserve decided to lower the fed funds rate by 0.5%, from a peak of 6.5% to 6% (remember when rates were that high?  Neither do I.).  There was a massive rally that day, and the S&P 500 went up by 5% that day compared with the day before, pretty much inline with the performance yesterday.  However, in 6 months, you would have lost 3.8% (including the 5% gain that day), in 1 year you would have lost 9.2% and in two years 29.2%!  On September 18, 2007, the Fed started lowering rates with a 0.5% cut from 5.25% to 4.75%.  As we fully know, this really didn't help much.  That day the S&P 500 rallied by 2.9%.  But in 6 months it was down 9.9%, in 1 year it was down 18.3% and in 2 years it was down 27.7%! 

Another issue is that it is unclear what the Fed plan will be this time around.  Clearly, rates can't go any lower as they are nominally zero and quite negative in real terms when you take inflation into account, so they are pretty much paying people to take the money (it's pretty scary that the economy is in such dire straits with such an already loose monetary policy).  They can always do QE3, where they buy treasuries on the open market.  The thinking goes, the money that treasury dealers get from the Fed, they then invest in other places.  With QE2, that meant the US stock market, emerging markets and commodities.  There is no such thing as a free lunch however and one could argue that quantitative easing has been a net negative economically as it caused commodity/energy prices to go through the roof, hurting the disposable income from consumers (70% of the economy).  As I mentioned before, at the tail end of QE2, you actually saw personal consumption expenditure fall for 3 months in a row in the second quarter, and that was after practically no growth at all in the first quarter.  As the S&P eventually does trade on earnings, margin compression from higher raw materials coupled with a slower economy will hurt stocks, even if some of the more momentum-oriented players do react positively to a QE3 announcement.  Another problem with the Fed buying more bonds is that it's balance sheet is currently leveraged about 54:1.  And people thought Lehman;s 30:1 leverage was insane.  Now I'm not saying the Fed can go the way of Lehman, it definitely won't, but the leverage could be problematic at some point.

Also, remember that the current crisis is only partially due to what is happening here.  Europe is the main culprit and the Fed has little to no control over what happens there and unfortunately our banks have $640 billion in exposure to the PIIGS alone!