Could Fed Moves Just Be Setting Up a 'Sucker's Rally'?

Getting in on a Federal Reserve-induced stock market rally that began in late August has been a pretty easy call. The hard part will come in deciding where to get out.


While many are taking the don't-fight-the-Fedtack, skeptics think that the easy-money rally will come with an inflationary price down the road and end quickly when the backlash hits.

Among the dangers they see are that the central bank might succumb to global pressure to stop printing money and devaluing the currency; there's also the possibility that the $600 billion program to buy Treasurys and drive down rates might not succeed in resuscitating the economy.

In the worst-case scenario, investors could find themselves in what David Rosenberg, strategist and economist at Gluskin Sheff in Toronto, calls a "sucker's rally."

"[A]ll we know is that these Fed-led asset cycles end in tears, and few manage to get out early enough because greed is an emotion that may go comatose in a brutal bear market but it never fully expires," Rosenberg wrote in a note to investors. "In other words, quantitative easings are no antidote for structural economic problems, even if they manage to give investors a short-term sugar high."

There already were signs that the rally is sputtering, with the market negative on consecutive days for the first time since September and uncertainty prevailing over European sovereign debt.

The Standard & Poor's 500broad stock market index has risen 16 percent since Fed Chairman Ben Bernanke first indicated, during a speech at the central bank's Jackson Hole summit in late August, that the Fed was inclined to start another round of easing.

The market is up more than 82 percent since the March 2009 lows, a time during which the Fed balance sheet has surged to $2.3 trillion and the US dollar has been on a steady drop. Stocks and the dollar have mostly been moving in opposite directions.

Such a liquidity-induced rally that has come even as unemployment has stayed near 10 percent and the housing market has remained mired in a slump of historical proportions is arousing suspicion over how long it will last and what happens when it's over.

"[W]e think those who want to play the game on the long side need to be ready to head for the exits quickly," research firm TrimTabs wrote in a nonetheless "fully bullish" market analysis earlier this week. "If a spike in interest rates, a surge in commodity prices, or a currency crisis forces the Fed to scale back or stop its money printing, the party could grind to a halt, and the hangover could be nasty."

Investors, then, should follow themes that incorporate the second round of quantitative easing, or QE2, along with a longer-view strategy in which multinationals that do large percentages of business abroad will benefit, said analysts at UBS Investment Research.

"The theme of investing in global growers, especially companies that have exposure to emerging markets infrastructure, is very sound long-term, and QE2 sort of adds to the story in the near term," UBS strategist Thomas M. Doerflinger said in an interview. "The competitiveness of those US companies, especially if they export into emerging markets, at least in part should be enhanced by a weaker dollar."

The downside risk is that if the Fed's continued money-printing faces intensified opposition both domestically and globally, the central bank could be pressured to quit or risk inflation.

Indeed, while the Fed is supposed to be politically independent, there likely will be a growing call to tighten once the Republican-controlled House of Representatives takes power in January.

"In nominal terms they can do whatever they want. They're the puppet masters," said Lawrence Creatura, portfolio manager of the Rochester, N.Y.-based Federated Clover Small Value Fund . "In real terms, it's a different story. But what's interesting is the unanimity of critics to QE2. Investors should recognize that and be cautioned that all of this could reverse direction with a single press release. So be careful."

Pro: 'Sell What They're Not Buying'

Market sentiment, at least, seems to have turned the Fed's way.

Equity funds reported their third consecutive week of positive inflows for the period ending Nov. 3, with domestic equity funds breaking a six-month string of outflows by posting inflows of $102 million, according to Lipper data. Investors have taken $52 billion out of equity mutual funds and exchange-traded funds this year, but a growing level of bullishness could change that.

Such trends are often considered contrarian—in other words, when everybody is doing one thing, that usually means the opposite is likely to occur.

"At this point my hope would be now that they've taken the dollar way down low, now that they're putting so much money out on the street they'll take some money off the street...and we don't get into a landslide devaluation of the dollar." -Currency Director,CompassFX, Dean Malone

At the same time, bond investors, who poured $68 billion into funds just in the last quarter, have been left in a bit of a quandary. The bond markethad been on a major bull run but saw selling on the long end when the Fed unexpectedly indicated that most of its Treasury buying would be of shorter-dated maturities.

It seemed to be another leg in the strategy of getting invetors out of safe investments and into risk, as buying two- and five-year notes makes little sense with such anemic yields.

"Everyone else is talking about buying what the Fed is buying. But it seems that the market has already priced that in, and that was very aggressive," said Kevin Ferry, president of Cronus Futures Management in Chicago. "You should be selling what they're not buying. That's what's happening."

Indeed, 30-year bonds have seen yields jump from 3.93 percent prior to the Fed's meeting to 4.25 percent in Wednesday trading, the highest since June 10. A higher yield reflects less demand.

The S&P 500 probably will be the less risky trade as long as the current Fed policies continue, Ferry said, even though the rally paused Monday and Tuesday as investors waited for devlopments out of the G20 meetings.

A related question on investors' minds is how low will be too low for the dollar, and what effect will it have on the market when the greenback starts rising.

"At this point my hope would be now that they've taken the dollar way down low, now that they're putting so much money out on the street they'll take some money off the street...and we don't get into a landslide devaluation of the dollar," said Dean Malone, currency director at CompassFX in Richardson, Texas.

In the meantime, technicians are generally calling for the S&P to keep moving higher and test 1,250 to 1,300 by the time 2011 rolls around—but with a test of the all-time closing high of 1,565 on Oct. 9, 2007 somewhere on a distant horizon.

"As soon as we get through earnings season we could continue to see a rally to the end of the year," said Dave Lutz, managing director of trading at Stifel Nicolaus in Baltimore. "People would rather see a slow crawl back to 1,500 then a jump there. That feels like it would be a more stable move."