Mere speculation that the Federal Reserve will pump more steroids into the economy has juiced the stock market in recent weeks. But many Wall Street analysts are now worried that the performance-enhancing benefits of a third round of bond buying will wear off quickly on stocks even if the Fed launches a new stimulus program today as expected.
Wall Street is betting the Fed will announce a large-scale asset-purchase program for the third-consecutive year when it concludes its two-day meeting today. Fed Chairman Ben Bernanke hinted in a speech two weeks ago in Jackson Hole, Wyo., that a third round of quantitative easing, or QE3, was still on the table due to the continued weakness in the job market and economy.
The Standard & Poor's 500 is up nearly 6% since the Fed's June 20 meeting when it specified that its future stimulus moves would be dictated by the health of the job market. A disappointing August jobs report, many on Wall Street believe, has given Bernanke a green light to launch QE3.
But the rally in advance of today's Fed meeting has analysts warning that the Fed's expected move may already be baked into stock prices. They also warn that stocks could fall if the central bank doesn't deliver.
"Following a sizable move (since the Fed first signaled QE3 is likely), much of the QE3-related stock rally looks priced in," says Barry Knapp, head of U.S. equity strategy at Barclays.
In order for stocks to push higher, Knapp says, economic data must improve, as does the public policy outlook related to taxes and U.S. debt problems. Despite more than three years of Fed stimulus, the nation's unemployment rate has been above the elevated rate of 8.3% for 43 consecutive months.
"Our main theme is we will need something else to go right to drive stock prices higher," Knapp adds.
With expectations high for the Fed to do something big, risks of market disappointment abound, warns Lance Roberts, chief strategist at StreetTalk Advisors. Many investors are hoping the Fed will announce either sizable purchases of bonds in the neighborhood of $600 billion or simply say the new program will be open-ended.
If all the Fed says is that it will extend its pledge to keep short-term rates around 0% into late 2015, from 2014, investor reaction is likely to be negative.
"Unless QE3 is going to be really gigantic, it will turn out to be a disappointment," Roberts says.
If the Fed doesn't launch QE3 but hints that it is still coming, stocks could suffer a 5% drop before rebounding on "hopes" that the next round of quantitative easing will occur at the Fed's October meeting or after the election.
The downside wild card is if the Fed reduces hopes of QE3 altogether, which is not expected. If that were to occur, stocks could fall 10% to 15% as investors refocus on the weak economy as opposed to central bank stimulus.
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