Earnings have been good this quarter, but earnings are not the primary driver of the recent stock market strength.  If earnings were driving the market higher, one would expect interest rates to firm.  But that is not happening as rates have collapsed and the dollar gets whacked every day.

What would cause stocks to rise, bonds to rise (and concurrently interest rates to fall) and the dollar to fall?  That would be quantitative easing (QE).

There is anticipation in front of the Fed meeting on Tuesday that the Federal Reserve will announce further quantitative easing to counter-act the deflation that is seeping its way into the economy. 

The first round of quantitative easing ended in March after the Fed finished purchasing over a trillion dollars of mortgages and government bonds.  Since then, a mere four months later, the economy is threatening to dip back into recession.

Economists are forecasting economic growth of 2.5-3% this year.  I think that will be wrong.  A favorite economic index of mine is constructed by a money manager who uses 22 leading and concurrent economic indicators.  It was remarkably prescient at predicting both the Great Recession and the subsequent recovery.  Today, it is in contraction mode, implying negative growth in the second half of the year.

I am loathe to rely on one sole indicator to make investment decisions. However, the Fed is also worried about the economy slipping back into recession, hence the noise about the need for further quantitative easing.

The effects of quantitative easing on asset prices is as follows.  The central bank purchases securities from banks (or the market), injecting cash into the financial system.  Cash earns nothing, so banks and investors turn around and use that cash to buy something else, bidding up asset prices.  Hopefully, for the Fed, interest rates fall and asset prices rise. 

In the last round of quantitative easing, the Fed primarily bought mortgages.  This time, the Fed is primarily going to buy – allegedly – government debt.  This explains, at least in part, why interest rates are collapsing and stocks are rising – the market is anticipating that the cash injections will lead to higher prices.  If deflationary fears were driving the market, stocks should also be falling.  But they are not.  At least not yet.

The dollar goes down every day because QE is the monetization of government debt, which is inherently inflationary.  The goal of the Fed is to create enough inflation to counter the forces of deflation in the economy.  However, that inflation also bleeds into asset markets.

It would certainly surprise me if the Fed did nothing.  Currently, the political environment is leaning heavily towards deflation.  Governments in Europe are talking about reducing budget deficits while it appears that the Republicans are poised to make significant gains in the November elections.  If the Fed opts not to being a new round of QE, I would expect a sharp correction in asset prices.

Of course, another round of QE is enormously bullish for gold.  Gold is correcting as fears about European sovereign default dissipate.  Investors have been comforted by the actions of European governments to address the Greek situation, the increased focus on budget deficits, and the so-called stress tests for European banks.  However, deflation is enormously bearish for the European financial system, which is in worse shape than the financial system in America.  I am afraid that the Extend-and-Pretend policies of the European governments are merely kicking the can down the road.  Ultimately, I believe European governments will also act to counter deflation.  If ultimately deflation wins out, gold is going down, but I am betting on the guys with the printing presses.  I have no exposure to gold at the moment but am watching carefully for entry points.

I am currently 80% in cash, my highest allocation ever, and my equity exposure is completely hedged out. (As regular readers of this blog know, I can change my mind in a heart-beat and get aggressively long or short tomorrow, and I won't tell you about it.)  Over the near term, it appears to me that the market wants to go higher.  Chart formations suggest such and the typical intra-day trading pattern over the past two weeks has been the market trading strong into the close, which is bullish.  However, volume is on fumes – Monday was the lightest volume day of the year – and the machines are pushing markets around as correlations between different asset markets are at or near all-time highs.  Thus, I remain on the sidelines, watching and waiting.