www.mksense.blogspot.com
Bill Gross (rightly) criticizes QE2, Jeremy Grantham (correctly) explains how we got into this economic mess and why structural changes will prevent a return to the economy of the past 20 years and the size a pace of QE2 comes into question and panic grips the market. The prospects of a modest QE2 pushed stocks and commodities lower and the dollar higher. The stronger dollar and the resulting rise of commodity prices is an obvious relationship, but what some investors just don't get is why QE2 drives equity prices.
The knee-jerk response is: The equity market responds positively to QE2 because QE2 will increase growth. Sorry boys and girls, no one except for CNBC anchors believe that (and not even all of them believe it). Another response might be that QE2 will weaken the dollar and increase exports and that will keep balance sheets healthy. That is true, but that isn't the main reason.
The driving factor is leverage. QE2 involves buying treasuries which keeps rates low. This makes leverage cheap. Stocks are being bought with this cheap leverage. Unless this cheap leverage continues or we see a sharp economic recovery the equity market could see a correction. Fortunately for equity investors QE2 is coming to some degree. This will put of the day of reckoning for awhile. However, cheap leverage can't last forever and the economy is structurally incapable of the growth to which we have become accustomed. Beware high yield bonds as well.
I strongly suggest reading Jeremy Grantham's GMO report.
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