11/12/2010
By David Urani, Research Analyst

Quantitative easing Part Two(QE2): it doesn't really roll off the tongue, and it gives one sort of a bittersweet feeling with its promise of stimulus combined with its blatant fabrication of new money hot off the printing presses. Yet, QE2 is the reality now and with it, a need to adapt our expectations for the market.  Under QE2, the program is to inject money through the primary dealers in Permanent Open Market Operations (POMO). The schedule for the next month has been set and these operations are set to happen almost daily (usually between 10:15 and 11:00) from now until December 9.  Usually, the injections range between $6 billion and $9 billion per day, and presumably it will continue through June 30, 2011. 

When primary dealers get this money, one obvious outlet for it is the stock market.  Thus, it is entirely realistic that these POMO operations will have a significant effect on the equity market.   After all, Ben Bernanke himself has noted before that a rising stock market can do good things for consumer confidence. We've seen those same thoughts echoed by former Fed chief Alan Greenspan, so market stimulus certainly has some allure from the Fed's standpoint. So then, should we expect a bull market over the next eight months?

Actually, the Fed had been conducting smaller POMO's under a separate program between August 17 and November 8 so we thought we'd analyze the results. As it turns out, since August 17, the S&P is up an average of 3.9 points per day on days with POMO operations.  Likewise, the market is up just 1.0 points per day on non-POMO days. On the chart below, one can see that there appears to be somewhat of a positive correlation between the performance of the S&P 500 and the level of POMO spending.

Additionally, the market appears to react more strongly on days with larger POMO acceptance. Since the new QE2 POMO's are generally larger than those of the previous program, we decided to look at the average performance of the market on the days that there was a POMO with an acceptance greater than $5 billion. As it turns out, the S&P was up an average of 11.7 points on those days, which is nothing to sneeze at.

Of course, POMO operations will not always be a market driver, but rather a market influencer. Take for instance August 19 when there was a relatively large POMO of $3.6 billion but the S&P went down 18.5 points; on that day there were very poor reports on initial jobless claims and Philadelphia region manufacturing. So then, fundamental market factors are likely to always be the driving force of the market, in general. Even so, if those reports hadn't come out that day one would have to wonder if the S&P would have traded higher through POMO. In fact, we have seen the market become quite resilient on POMO days, particularly on September 28 when a horrid consumer confidence number sent the Dow down approximately 90 points from the open. Subsequently, at 10:15 the POMO operation for that day began and immediately the market began to surge, eventually finishing 46 points in the green.

November 12 was the first day of the QE2 POMO's and it pulled in $7.2 billion. By the aforementioned trends, one would expect the market to have been much higher but in actuality, the major indices crashed. Once again, fundamentals were to blame, including fears of Chinese economic tightening measures and an impending bailout (or default) of Ireland. Therefore, quantitative easing should not be a reason to automatically put money into the market, as investors still need to be aware of the news. However, on a calm trading day with a POMO operation (POMO's will be nearly every day under the current schedule), don't be surprised to see your portfolio rise.

David Urani
Wall Street Strategies

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