Chris Kuflik - ScotiaMcLeod Montreal

It’s Official. The Quantitative Easing (QE2) that the US Fed put forth Wednesday is a success… at least a one day success as shown by the global markets performance Thursday. The bulls stampeded and global stock markets rose significantly. The most asked question for me today is: “Can this rally continue?”

Wednesday afternoon, the Fed announced that they will add liquidity to the US financial system through the purchase of $600 billion in Treasuries over the next eight months. In addition, they will continue to buy another $275 billion in treasuries funded by the ‘re-investment’ of interest and maturities from the mortgage securities purchased in QE1.

More adrenaline was given to the bulls Thursday when President Obama, in a conciliatory gesture to the Republicans, hinted that he may extend the Bush tax cuts on capital gains and dividends past December 31^st. Previously, Obama had said that he was firmly against extending the cuts. This gesture, if passed, will remove some of the tax gain selling pressure (sell now to pay a lower tax rate) that was expected to occur over the next two months. It should be noted that selling by insiders had increased dramatically in September and October. This insider selling is usually a sign of lower future stock prices, but it is unknown how much of this selling was done for tax purposes.

To answer the question if this rally can continue, it is prudent to examine both sides of the argument.  

Credit Suisse’s global equity strategy team feels that QE2 will be more effective than most realize. Here are some of their key bullish arguments:

1. Negative US real rates up to 7 years have made government funding arithmetic more favourable.
2. Lower real yields have led to record housing affordability and a re-rating of assets.
3. The Fed is likely to buy proportionally more assets from non-banks than in QE1 and this directly helps improve the funds flow effect.
4. A weaker dollar effectively causes QE to be expanded in Japan, as well as bringing about a GEM liquidity/asset bubble.
5. During QE1, equities nearly doubled and QE2 is already working (inflation expectations have risen by 92bp since Bernanke’s Jackson Hole speech at the end of August).

Credit Suisse recommends staying in overweight equities as they view them as the cheapest available inflation hedge. They do expect that this and possibly further rounds of quantitative easing will become inflationary.

Many bears do not believe that QE2 will be enough to stimulate growth and could lead to many unintended future problems. Goldman Sachs economists recently concluded that it would take another 4 trillion in quantitative easing (QE) to stimulate growth. The bears point out that the first round of QE (600 billion) was announced in November 2008. That figure was increased to 1.8 trillion four months later. This amount, while it stabilized the US economy, did little to address the roots of the problems. They point out that:

1. Unemployment remains high.
2. US housing is getting worse.
3. Credit continues to contract and the availability of credit is tight.
4. The US dollar continues to fall, creating an additional tax on an already struggling US consumer, which will cause them to spend less on non-essential items (the US consumer represents approximately 2/3rds of GDP).
5. Inflation from essential items, such as food and energy, caused by a declining dollar, is difficult to stop.

The rally on Thursday had many signs of a “blow off top”. Gold jumped over $50 an ounce to close at a new record high just shy of $1,400. The world financial system remains in a very fragile state. While the Fed is telling the investing world that it will use its powers to stimulate growth, history has shown this policy to only be marginally effective. While I hope that it works this time, I have my suspicions whether or not it will.

We will continue to monitor positions closely and employ stop losses to protect our gains.

Please feel free to share this with someone who you think could benefit from its contents.

Chris Kuflik

Associate Director, Wealth Management

Wealth Advisor

514-287-2931

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Visit our website at www.chriskwealth.com

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