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Comstock Partners, Inc.
Fed Determined, But Tools Are Limited
September 13, 2012

The Fed's initiation of QE3 (or QE Forever) is a desperate attempt to fight off the severe headwinds that are still hampering the economy four years after the onset of the credit crisis.  For months now the market has been almost completely dependent on the Fed and the ECB as they are virtually the only game in town, while everything else is seemingly going downhill.  Most of the global economy is either slowing down or already in recession, while corporate earnings that also propped up the market for so long are now being revised downward.  The market is facing uncertain elections, a paralyzed federal government and the highly publicized but still dangerous fiscal cliff.

Underlying the malaise in the economy is the vast overhang of household debt and low savings rates that is discouraging robust consumer spending.  Households are in the process of increasing savings rates and reducing debt, restricting their buying to what is necessary or to replacing aging goods.  In addition consumers are suffering from weak employment, minimal wage increases, lower net worth and scarce credit that is available only to prime borrowers.  Although corporations are already flush with cash, they have little incentive to expand or hire people in the face of light demand.

In response, the Fed, today, decided to initiate QE3, a program to buy $40 billion a month of mortgage-backed securities on an open-ended basis in addition to the $45 billion in operation twist that ends in December.  In addition the Fed extended until mid-2015 the period during which it keeps the funds rate between zero and 0.25%.  In his press conference following the FOMC meeting, Chairman Bernanke stated that the pace of economic growth was inadequate to bring down the rate of unemployment that is unacceptably high and that the Fed intended to employ tools that would bring the unemployment rate down.

Bernanke made it clear that the Fed's tools were limited and that the Fed could not fix the economy by itself.  He stated that their tools were meant to boost asset prices----namely housing and stocks----and to make their communications transparent.  To this end the bond purchases were meant to goose asset prices while the extension of monetary ease to mid-2015 was intended to show strong commitment.

In our view the Fed's policy will not be effective. Although QE1 was effective in saving the financial and economic system from collapse, QE2 and operation twist did not result in much economic growth and we are approaching a point of diminishing returns.  In fact, QE3 could well have some undesirable results as well.  Today's action was immediately greeted with a rise in long bond yields, a jump in wide array of commodities and a weaker dollar.  While some were quick to see this as inflationary, it is more likely to reduce real consumer income and ultimately be deflationary.

It therefore appears that QE3, far from being a panacea, is a desperate attempt to do something when nothing else is working.  Current quarter GDP appears likely to become the third quarter out the last five to show growth below 2%.  S&P 500 earnings estimates have started to drop, a process that is only in its early stages.  Europe's problems are well known, and as we mentioned last week, are far from solved.  China's investment bubble is fading while net exports are declining at the same time that the goals of reducing savings and increasing consumer spending are not being met.  Japan's economy is in a third lost decade and the BRICs other than China, with their export-oriented economies, are also having problems.  Despite today's rally, we don't think the stock market has much going for it under current and prospective conditions.  

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