February 27, 2013 at 09:33 AM EST
How the Bad Habit of Stock Markets Will Kill Investors’ Returns

Stock markets in the U.S. economy have developed a bad habit—going up on quantitative easing and falling when it stops.

Look at the chart below:

$SPX S&P 500 Large Corp Index stock market chart

Chart courtesy of www.StockCharts.com

In 2008, when the Federal Reserve announced its first round of quantitative easing, stock market investors loved it, as key stock indices, including the S&P 500 and the Dow Jones Industrial Average, rallied. The returns were phenomenal for a very short period of time; but in early 2010, when quantitative easing ended, the stock market declined.

From there, the vicious cycle continued—a stock market rally on quantitative easing news and a sell-off at its end.

As I have been harping on about in these pages, this is not a sustainable policy. A stock market being propped up by quantitative easing does not equal economic growth in the U.S. economy. First, businesses in the economy must grow; second, individuals in the U.S. economy must be confident with their income; only then does an increase in consumer spending and jobs follow.

Unfortunately, quantitative easing didn’t do what it was supposed to do—spur real economic growth in the U.S. economy. Rather, it pushed up the stock market and sent bond prices plummeting.

I’m convinced the stock market is not rising because of the lack of corporate earnings growth or better future expectations. As a matter of fact, those who are closest to public companies—corporate insiders—are selling stocks at near-record levels, while corporate earnings growth for the first quarter of 2013 may now be negative.

For the week ended Wednesday, February 13, 2013, the Investment Company Institute reported that long-term equity mutual funds saw inflows of $5.72 billion. In the previous week, mutual funds saw $6.0 billion in new money come in. (Source: Investment Company Institute, February 30, 2013.) Investors are running toward the stock market, and as history has proven time and time again, the individual investor is often wrong.

Mark my words: any minor pullback will lead to an extensive sell-off in the stock market. Remember 2008? Stock market investors sold in a panic, because their losses were growing.

Now consider this; there is already some disagreement between the members of the Federal Reserve about keeping quantitative easing going at its current pace, as there will be serious risks if paper money printing continues—inflation, asset bubbles, and the declining value of the dollar are just the beginning.

If the past is any indicator, as soon as the Federal Reserve reduces its quantitative easing program, the stock market decline could be significant. As their losses accumulate, stock market investors will sell, and the sell-off will take flight. Capital preservation seems to be the best strategy in the current market…a stock market filled with optimism and artificial quantitative easing.

What He Said:

“If the U.S. housing market continues to fall apart, like I predict it will, the stock prices of major American banks that lend money to consumers to buy homes will come under pressure—these are the bank stocks I wouldn’t own.” Michael Lombardi in PROFIT CONFIDENTIAL, May 2, 2007. From May 2007 to November 2008, the Dow Jones U.S. Bank Index of the world’s largest bank stocks was down 65%.

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