How to Invest in the Stock Market: Protecting Yourself from Federal Reserve Quantitative Easing

Comments on Federal Reserve’s policy made by Chairman Ben Bernanke at Jackson Hole, WY on August 27 have recently had a major influence on the course of stock and commodity prices.

Bernanke acknowledged high unemployment levels, slow growth, and tight credit availability are restraining growth in household spending. He added that the Federal Reserve would engage in another phase of large-scale asset purchases to lower interest rates and stimulate growth, a process economists dub quantitative easing.

While the Federal Reserve’s policy statement has helped to dampen fears over the U. S. slipping into another recession, fears of inflation have risen considerably.

Market Reaction to Federal Reserve Quantitative Easing Phase 2

The U. S. dollar has slid against most major currencies setting an all-time low against the Swiss franc. Gold has set a new all-time high and silver has risen to a 30-year high.Market Reaction to Federal Reserve Quantitative Easing Phase 2.

In the fixed income market, the price of the intermediate-term 10-year treasury has gained on expectation that the Federal Reserve will be a big buyer whereas the threat of inflation has caused the price of the long-term 30-year treasury to decline.

Price Changes since Federal Reserve outlined
Quantitative Easing Phase 2 on August 27, 2010

Corporations and private-equity firms are taking advantage of low interest rates to lower their cost of capital and acquire businesses. According to Bloomberg, U. S. companies issued over $160 billion in corporate bonds in September, the second-busiest month on record. American Express (AXP), General Electric (GE), Hewlett-Packard (HPQ), and Microsoft (MSFT) were among the larger debt issuers.

M&A activity is on the rise with hostile pursuits having their share. Intel (INTC) is buying McAfee (MFE) for $8 billion while private equity firm 3G Capital is buying Burger King (BKC) for over $3 billion. BHP Billiton (BHP) & Potash Corp (POT) and Sanofi-Aventis (SNY) & Genzyme (GENZ) are engaged in hostilities.

Rising deal activity and receding recession fears have spurred stock prices. The S&P 500 has rallied 11% since August 27 and is within 3% of 2010’s high. The backdrop of a falling greenback has boosted returns on foreign stocks.

Will Federal Reserve’s Quantitative Easing Reduce Unemployment?

Last Friday, Bernanke appeared to set the stage for announcing specific asset purchase plans after the next Federal Reserve meeting ends on November 3. Bernanke stated that high unemployment poses a great threat to the economy. Downplaying the price stability imperative, he said the central bank must weigh deflation risk rather than maintain its traditional concern on inflation.

I have my doubts if quantitative easing is likely to help in reducing unemployment. Through the Phase 1 part of quantitative easing, the Federal Reserve purchased nearly $2 trillion in assets over the last two years. While these purchases have lowered market interest rates and helped to stabilize the economy, they have not helped to generate many jobs. Furthermore, the recent acceleration in corporate takeovers could lead to more layoffs down the road rather than create jobs.

How Should You Invest in this Stock Market?

It remains to be seen if the Federal Reserve will pursue phase 2 of quantitative easing. If it does, the central bank has to get the stimulus magnitude and pace of asset purchases right. As upticks in the price of gold and long-term bond yields already suggest, too much stimulus would result in rising inflation expectations, an undesirable consequence.

To stay ahead of the curve in this uncertain environment, you need to emphasize safety by holding adequate cash, diversifying in the right mix of assets, and owing the right types of stocks.

Hold cash: Even though short-term instruments yield close to zero, cash is a ‘must-have’ for most investors in this environment. It will help you reduce downside risk and exploit market volatility.

Have right asset mix: Owning assets like international stocks and commodities in modest amounts as part of a diversified portfolio can help offset the negative impact of a declining dollar and rising inflation. Given that commodities and to a lesser extent international stocks are up quite a bit recently, waiting for a pullback or buying such assets in incremental amounts over time would be sensible.

Own right stocks: With the U. S. economy needing stimulus to continue growing, ‘conservative investing’ should be the order of the day for most investors. You can minimize downside risk by emphasizing quality and valuation. Even if a bearish phase ensues and stocks sell off, quality stocks trading at modest valuations stand a better chance of regaining lost ground and returning to the black. If you are in the fortunate situation of owning stocks that have gone up a lot, here is a good ‘house keeping’ opportunity for you to weed out the low quality ones.