QE2 ends at the end of the month

It is an understatement to say the world has experienced a radical shift in capital markets. There are more layers of information and opinions on the direction of the world than we've seen in decades. The Internet and the media do not always make it easier, but Michael Dubis' regular contribution through IB blogs will help you sift through the noise and give you some perspective. Read Full Bio

Some of you might be wondering: What does this mean? Or even “what is QE”? Some of you may know what QE is and feel it’s yet another negative in the world of capital markets. Some of you may simply not care. Either way, the end of QE2 is simply one of a laundry list of unknowns in the world that are influencing how we think about the future.

Quantitative easing (QE) is a monetary policy tool used by our central bank (among others in the world) to attempt to “stimulate” the economy when normal monetary policy isn’t working (normal is a very subjective issue as well). Basically, the central bank (Federal Reserve) purchases assets normally from banks and other private sector businesses with new money that it creates electronically. This then increases the reserves banks have to hold so that yields can drop. This drop of yields then should encourage more lending and investing. It also raises the prices of the financial assets.

In other words, printing money (electronically) and then placing it into the “marketplace” with the expectation that the U.S. and world economies would be “stimulated” by the cheap cost of capital (i.e., low interest rates).

This has worked somewhat in that the world stock markets have essentially doubled in value since their 2008 and 2009 lows. I personally don’t view this “asset inflation” as an entirely good thing. But this has allowed the private sector and consumers to shore up their balance sheets and improve their debt-to-equity ratios. Interest rates on lending also remain at historic lows.

Unfortunately, the plan was for the economy to pick up significantly, which has not occurred. Unemployment exceeds 9% on the record and likely 15% off the record. It is also definitely NOT working for Greece. Austerity is coming to Greece (and probably some other countries as well). Austerity is simply paying taxes, paying bills, paying debts, giving up luxuries, and doing your job. Yet, in Greece, they’re protesting this idea. That’s a problem. I hope that mindset doesn’t spread here.

Furthermore, if you are a saver or are holding bonds, you are getting hammered relative to what you were once receiving on your bond ladders and money market rates. In other words, you’re partially subsidizing QE. This is also partly why other assets (i.e., stocks) have risen so much in the past two years: because savers are sick of the low yields and are taking on greater risk to get a slightly better yield. Unfortunately, this is dangerous for someone who really needs safety, but it’s understandable why folks are chasing returns.

So many argue that stock markets are now so highly valued (i.e., expensive) that forward-looking returns will not look like what we’ve just seen. They also say bond yields are so low that a correction will occur here as well. Some even suggest quite persuasively that the markets are ready for another correction (perhaps we’re already in the middle of that correction). I can recap strong cases for a bull market and a bear market. This is, unfortunately, a delusional discussion because it’s so varied, so instead I think it’s best to focus on risk management and long-term goals and plan around bull and bear markets, but designed around your own unique circumstances.

The long term, though, is also an issue. Are we in a cyclical bear market or are we facing a structural change? Now that the stimulation is ending at the end of the month, we are left wondering: what next? This amount of QE is unprecedented in the history of capital markets, so essentially it’s one big experiment. Relying on the past to predict the future is, in my opinion, also delusional.

Many experts believe there will be no further stimulus, although some say there should be. It is likely the Federal Reserve will sit tight and see how the U.S. and world economies handle the loss of stimulus. The government hopes things will get better. The problem, though, is that if you look at who buys U.S. debt, it was almost all the Federal Reserve over the past year, with foreign investors pretty much out of the picture, including the Chinese. Of interesting note, if Greece defaults on its debt, there will likely be a flight to quality in U.S. Treasuries … how interesting the timing of QE2 ending this week and Greece at the center stage of default on its bonds.

Anyway, I digress. If foreign countries don’t return to the U.S. Treasury purchases, then the U.S. private sector might have to pick up the pace. If the private sector buys the Treasuries, it is very likely that it (i.e., you and I) will want to buy these bonds with better yields than we’re getting today. It’s entirely possible foreign investors will want the same. If that happens, it is entirely likely that stocks will have to fall because the demand for stocks will fall in favor of higher-yielding Treasury bonds. When QE Part I ended in the spring of 2010, stocks sold off sharply and only recovered when QE2 was underway in October 2010.

If there is another round of QE, then it’s possible stocks will rise or stay stable and interest rates will stay low. Japan has been in a scenario of low interest rates for decades, so it’s not entirely unlikely that interest rates will stay low. Unfortunately, it seems all that would happen in that scenario is that we’d postpone the inevitable day when we simply can’t or shouldn’t print any more money. If we happen to end up like Japan, I can assure you investors will not be happy with sideways markets for 20 years in the U.S.

Even though the political environment does not support further government intervention, my sense is that QE Part 3 may be on the horizon because right now it doesn’t appear that the U.S. economy is picking up the pace.

If we need to correct a structural problem in the short term, it will most likely mean significant changes in valuations around global capital markets, both bonds and stocks. In other words, volatility will surge. Increased volatility is simply the markets’ approach to assessing the risk around new information and unknowns. It doesn’t necessarily mean one abandons a well-thought-out plan. It also doesn’t necessarily mean all asset classes will drop in value. The idea of diversification is simply a rational approach to having exposure to different asset classes that benefit from different environments.

I would like to be wrong, but I simply don’t believe in the government’s ability to manage itself, let alone the capital markets. The government’s influence is unprecedented, and the results of its actions likely will be too. Consequently, I always argue that proactive planning and evaluation of multiple financial paradigms must take center stage in your financial life. Define a strategy.

So plan for ongoing ambiguity in the world. The end of QE is just one of many issues in the world that are different than anything in the past. Listing all of them is not very beneficial or practical for this medium. The general assumption that the world is dealing with a lot of unknowns is enough to understand you need a strategy, but it also doesn’t have to mean things are going to be or have to be bad.

Let’s not crawl into a cave. Optimism is a necessary component of capital markets’ functioning well. Again, U.S. corporations significantly shored up their balance sheets over the past year, and even in a volatile environment, they are in a much better position today than they were three years ago. Folks are far more sensitive to risk than they’ve been in decades. These are good things. And don’t lose sight of one very powerful and positive fact: When free to choose, people of the world will strive to be in a better place one, five, 10, and 20 years from now than they are today. This positive human condition bodes well for all of us. I’ve often said that hope is not a strategy, but it is still a necessary condition for us to strive and live well in the future.

Michael Dubis is a fee-only certified financial planner and president of Michael A. Dubis Financial Planning, LLC. He is also an adjunct lecturer at the University of Wisconsin Business School James A. Graaskamp Center for Real Estate. Mike can be reached at financialperspectives@gmail.com.

Sign up for the free IB Update – your weekly resource for local business news, analysis, voices, and the names you need to know. Click here.