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As Fed—and Markets—Pull Back, What Can Investors Do?

Now that QE2 is nearly history, QE1 a distant memory and QE3 increasingly unlikely, markets are charting what looks like a QE retreat.

A stock broker sits in front of a board displaying German share index DAX at the stock exchange in Frankfurt/M., western Germany.
Thomas Lohnes | AFP | Getty Images
A stock broker sits in front of a board displaying German share index DAX at the stock exchange in Frankfurt/M., western Germany.

Investors appear to be settling into a reality that the Federal Reserve is done with its quantitative easing—or QE—programs, a position cemented earlier this week in remarks from central bank Chairman Ben Bernanke.

That has turned into a significant development for the markets; the S&P 500 has dropped 2 percent this weekand is in the midst of a nearly 7 percent slide that began off the post-financial crisis highs of May 2.

While much of the loss in investor confidence can be traced to a decline in several key economic indicators, the loss of Fed asset-buying support has been the theme in the most recent leg down.

So with a slide Friday capping an ugly five-week stretch, the main question that seemed to loom was how bad the damage would get, and what investors should do as the market lets go of the Fed's head and moves forward.

"If you look at what values have been rising over the course of the quantitative easing program, it has been merely commodities and equities, nothing else," says Brian LaRose, strategist at United-ICAP in Jersey City, N.J. "Reality is starting to take hold."

LaRose believes that the end of easing will pop a bubble in stocks and commodities such as gold and oil, leading to a safe-haven surge in the US dollar. The greenback has lost nearly 10 percent of its value against the world's currencies since Bernanke signaled QE2 in a speech at Jackson Hole, Wyo., late in August 2010.

"The reality of the economic landscape is things have not gotten better. Home prices are still falling, people are still under water, people are not going back to work," says Brian LaRose, strategist at United-ICAP in Jersey City, N.J. "That's what drives this economy—consumer spending and housing. If you can't get those core ingredients, you have a recipe for a disaster and not for recovery."

With the Dow industrials sliding through the psychological barrier of 12,000 in Friday trading, attention turned to where a bottom might be found.

Hedge fund manager David Tepper, whose comments on CNBC last September that the Fed would ensure stocks stayed higher presaged a nearly 30 percent jump labeled the "Tepper Rally," said Friday this is a "difficult environment for investing" and recommended a short time frame.

Other opinions ran the gamut: Richard Ross, global technical analyst at Auerbach Grayson, said "the correction is just getting started," while Jeffrey Saut, chief investment strategist at Raymond James, called the market "bullishly configured" as long as the S&P holds technical strength around the 1230 to 1250 level.

Investor sentiment polls and fund flows have reflected a more cautious investor.

Domestic equity funds saw $1.31 billion in outflows for the week ended June 8 while taxable bond funds saw inflows of $4.525 billion, according to Lipper data.

"We have mountainous inflation efforts in place with historically low yields and strong demand for bonds. That's like a rubber band that's going to snap at some point and somebody's going to get hurt," says Bill Larkin, fixed income portfolio manager at Cabot Money Management in Salem, Mass.

"We have mountainous inflation efforts in place with historically low yields and strong demand for bonds. That's like a rubber band that's going to snap at some point and somebody's going to get hurt." -Portfolio managerCabot Money Management, Bill Larkin

"As a fixed income guy, I get nervous when I see things this expensive," he adds. "I'm trying to convince my clients that cash now is a good thing because we can be dynamic if we see a chance."

Larkin says he's taking a "shotgun approach" to bond investing, with diversity and a portfolio of high-yield municipal bonds and fixed-rate preferreds. He's holding 7 to 10 percent cash.

The behavior of investors during QE2 has been interesting beyond the obvious surge in stocks and commodities.

An analysis by Goldman Sachs economist Alec Phillips found that the bulk of the sellers of Treasurys who benefited during the the Fed's $600 billion buying spree bought government agency-backed securities such as mortgages, acquiring a net of $314 billion. The next most-popular destinations were corporate bonds, fed funds, money markets and mutual funds.

The bulk of the sellers was classified as "household," a group that notably includes hedge funds.

What's left now for investors is determining where to go now that the Fed won't be such a player in the Treasurys market.

Abigail Doolittle, who runs a boutique investment firm in Albany, N.Y. called Peak Theories Research and publishes a weekly newsletter, said a "tough love QE3 stance" could be good for the market over the long term.

"The Federal Reserve needs to work at engineering the strong dollar, rising rates recovery that will have more of a lasting effect and one that will resemble the missing third part of the current cycle and proof that this time around...is, in fact, different even though this is supposedly never true," Doolittle wrote Friday.

"Should this line of communication remain consistent, it could be the very thing—the best policy option available at this time—to force investors off of the liquidity high of the last few years and replace immediate-term gratification with long-term satisfaction of investing in an economy with a truly solid foundation."

Doolittle sees longer-term difficulties for the market but believes that in the near term the S&P 500 actually will rally t0 1,340.

The prescription of a slow-growth recovery with investor patience seems to be the great hope among market bulls as the Fed fades away.

"Quantitative easing has already gone on too long," Jim McCaughan, who runs Principal Global Investors, told CNBC. "The short-term implications are that progress will be slower, but it makes it more sustainable."