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The Pros and Cons of QE2

Simon Maierhofer

A picture says more than a thousand words and the chart below does just that. Take a minute to study the chart, and you'll also learn that it takes only one picture to expel a myth, regardless of how pervasive it is.The black line is the percentage increase of the Fed's adjusted monetary base since January 2007, or the amount the Fed has spent on quantitative easing and other fiscal maneuvers. According to the QE myth, a drastically rising monetary base will increase money supply and inflation.The grey line is the M2 money supply. To compare apples to apples, M2 is also illustrated as percentage increase. The blue line is inflation measured by CPI.There's really not much else to say about QE1. Of course, we could add an additional thousand words of CNBC-fluff-like analysis, but your time is better-spent examining other pressing QE related topics, like:Did stocks rally because of QE1? Will stocks rally because of QE2?     Timing is EverythingThe second chart (quantitative easing and the big picture) plots the S&P's performance against QE1.As you can see, QE1 came at a time (on March 18, 2009) when the S&P (SNP: ^GSPC) plummeted 57% from its October high. The Dow Jones (DJI: ^DJI), Nasdaq (Nasdaq: ^IXIC) and other broad market measures didn't fare any better.Needless to say, the market was extremely oversold. After predicting a bottom target of Dow 6,700, the ETF Profit Strategy Newsletter issued a strong buy alert on March 2, 2009. Stocks bottomed on March 6. By March 18 (when QE1 became official), the S&P had already soared 20%.          QE1 vs. QE2Timing is probably the main difference between QE1 and QE2. In terms of economic benchmarks, there hasn't been much improvement. Unemployment has risen from 8.6% in March 2009 to 9.6% (U-6 unemployment has gone from 15.6% to 17.1%). Real estate prices have failed to recover while consumer confidence is about at the same level today as it was in April 2009.What has changed is the stock market. The S&P today is nearly 80% above its March 2009 low. In other words, QE1 was launched after the major indexes lost some 57% while QE2 will be released after stocks have already rallied 80%. You decide which environment is more conducive for higher prices.What's Fueling the Stock and Commodity Rally?If you are a one-word-explanation kind of a person, the answer is liquidity.Fed-induced liquidity to be more accurate. Right now, banks (NYSEArca: KRE - News) and financial institutions (NYSEArca: XLF - News) are swimming in liquidity. Where does the liquidity come from?It's a complicated process, here's the short version (the longer version was discussed in the November ETF Profit Strategy Newsletter):Currently, banks are allowed to borrow money from the Fed at an interest rate of 0.25%. Of course, the average American can't borrow at 0.25%, but the biggest banks can.Guaranteed Profits for BanksWith the borrowed money, banks buy Treasuries. Long-term Treasuries (NYSEArca: TLT - News) pay about 3.5%. This is a guaranteed profitable trade. Pay 0.25% - get 3.5%. There's no incentive for banks to provide risky loans to broke consumers if the government offers you a no-loss option.In addition to the guaranteed margin profit, the Federal Reserve buys back Treasuries from banks via its Permanent Open Market Operations (POMO). Since Bond prices have gone up for most of the year, this is another profit source for banks. Buy low, sell high. Another government guaranteed trade.Where do all the profits go? Look around! A rising tide lifts all boats.  Domestic stocks, international stocks (NYSEArca: VEU - News), emerging market stocks (NYSEArca: EEM - News), broad bond funds (NYSEArca: AGG - News) and commodities (NYSEArca: DBC - News) are all up.Fly in the OintmentAll things come to an end eventually. Even this perfectly legal and unethical enrichment cycle the banks are feasting on.30-Year T-Bonds were the first to decouple themselves from the liquidity rally. They topped on August 25 and have been going down since. On that very day, the ETF Profit Strategy Newsletter stated that: 'Our technical analysis along with fundaments suggest that T-Bonds are getting ready to roll over.'Shortly thereafter, Bill Gross stated that the 30-year bond bull market is over. Lower bond prices mean higher bond interest rates. When interest rates rise, investors become less inclined to 'gamble' with stocks.And regarding the POMO repurchase profit racket, lower bond prices mean smaller profits for banks which translates into less money to drive up stocks and commodities. This alone probably won't be a big enough knock against the liquidity house of cards, but every crash has to start somewhere - bonds may be the beginning.Gold, Silver, Commodities and InflationThroughout much of 2008, 2009 and 2010, gold, silver and stocks have been moving in the same direction. That direction was usually the opposite of the U.S. dollar. A weak dollar means rising stocks and vice versa.If you look carefully, you'll see that the dollar has found support around current levels, which coincided with a correction in gold (NYSEArca: GLD - News) and silver (NYSEArca: SLV - News). In fact, gold has been correcting even though stocks have continued to rise. It's said that a fragmented market is an unhealthy market.This doesn't mean the patient (= various markets) can't live (= rise) longer, but it is an early warning sign.Short-Term Effects of QE2Leading up to today's Fed meeting, stocks have been rallying. If you believe 'buy the rumor and sell the news' will be the case, that's exactly the behavior you'd expect to see. Once the news is released, the big question is whether investors feel they actually got the steak or just the sizzle.Sentiment is extreme enough where a 'sizzle-induced' disappointment could lead to a correction - a correction bigger than many expect.Of course, there are many who believe that the ueber-bullish presidential election year cycle (October ETF Profit Strategy Newsletter, page 4) will kick in and propel stocks for the foreseeable future.Either way, we find ourselves at a very important juncture. The stock market has drawn a few lines in the sand, or trigger levels. A breakout above trigger levels will lead to the next resistance, while a drop below support may open the floodgates.The ETF Profit Strategy Newsletter provides a semi-weekly Technical Forecast with important support/resistance, trigger and safety levels.  It visually explains many technical indicators in an easy to understand manner. After all, a picture paints more than a thousand words.