How to trade QE3

The Fed has been very active in recent years, and certain patterns may have emerged.

• Fidelity Active Trader News
• – 10/18/2012

If you are an active market watcher, you have probably heard the term quantitative easing—QE for short—more than just about any other term in the past year or so.

The massive monetary stimulus policies—known as QE—that are undertaken by the Fed and designed to help the economy recover could have long-term implications. They could affect the fundamentals of the global economy in many ways, and, as a result, influence the everyday trading patterns of the stock market.

The chart below shows how the market responded to the first two QE programs, as well as to Operation Twist (a plan comprised of buying longer-dated bonds and selling shorter-term bonds with the intention of extending the maturity of the Fed’s portfolio), and the long-term refinancing operation (a QE program in all but name).

Monetary stimulus and the influence on the S&P 500 Index^®

A couple of patterns stand out. You can clearly see the uptrends that have taken place during each QE. However, there appear to be diminishing returns for each successive program. For example, during QE1, the market soared 80%, while QE2 resulted in a 33% gain. As of September 12, Operation Twist and the LTRO program produced a 29% rally.

Also, the market has had an adverse reaction when Fed stimulus has been withdrawn. After QE1 ended, the market dropped sharply until QE2 was announced by Fed Chairman Ben Bernanke at a conference in Jackson Hole in September 2010. Once again, in the aftermath of QE2, stocks plunged until Operation Twist went into effect.

Of course, there are many other factors that caused the market to advance and decline over this time period. But as the graph above suggests, the presence and withdrawal of QE appears to have been a catalyst for stocks.

Looking inside the pattern

What might these QE trading trends indicate? If past patterns persist, the market could continue to rally in the immediate aftermath of QE3, and when it is over, there might be a pullback.

But there are technical analysis tools that could suggest a more comprehensive strategy. Among them is Elliott wave theory, which was developed by Ralph Nelson Elliott. This technical analysis tool is primarily about assessing the psychology of investors. Elliott described this market psychology as a “rhythmical procedure,” which can result in identifiable patterns, or waves. If you are able to identify these waves, you might be able to trend-trade them.

Ching Tan, a technical analyst with Fidelity, thinks Elliott wave analysis suggests there could be tradable declines and rallies before the year ends. “Recognizing that Elliott wave analysis can be highly subjective, the pattern that has developed over the past couple years might lend itself to this type of ebb and flow cycle analysis,” says Tan.

One key to performing Elliott wave analysis is spotting where a wave begins. “If we mark the March 9, 2009 low as the beginning of a wave,” Tan says, “the first wave ended on April 23, 2010 after a gain of 541 points.”

Elliott wave analysis of the S&P 500 shows the rallies and declines in “waves”

According to Tan, that day also marked the beginning of a corrective wave (wave two), which ended on July 2, 2010, after a decline of 195 points. A new wave (wave three, or wave one of wave three) started that day and ended on April 29, 2011, after a 341-point advance. A corrective wave (wave four, or wave two of wave three) started that day and ended on October 3, 2011, with a decline of 264 points.

What might this price trend and cycle analysis indicate for the coming months? “A new primary wave started on October 3, and the high was made on September 14, 2012, with a gain of 367 points,” Tan states. “In the wake of this wave up, there might be a correction wave coming.”

Fundamentals such as the fiscal cliff or issues in Europe and Asia could be drivers of such a downward wave. “That correction might then be followed by another rally to complete the fifth wave,” Tan points out.

Trading implications

Elliott wave theory is just one method that can be used to analyze patterns like these, and, as noted, it is highly subjective. But Tan suggests that this type of cycle analysis might be useful in spotting broad trading patterns that could develop from the large-scale policies of the Fed.

Based on these historical patterns, it may be possible to infer several possible outcomes from the Fed’s announcement of QE3. A simple interpretation would be that, like QE1 and QE2, there could be a sustained uptrend while the Fed is actively supporting the economy. This could increase the attractiveness of bullish strategies, such as long stock and options positions. Then, when Fed stimulus is withdrawn, bearish strategies, such as short stock and options positions, might be attractive.

But as Tan’s Elliott wave analysis points out, there may be bullish and bearish waves within longer-term trends. And, of course, there are several forthcoming major market-related events that might override these patterns and the effects of QE, such as the fiscal cliff and the eurozone debt crisis.

Tan makes one final point: “It does not seem that the fifth wave of the wave three pattern is completed as of the September 14, 2012 high. In my view, this, combined with the general aggregate seasonality pattern and presidential election cycle, suggest higher prices toward the end of the year.”

Learn more

• Brush up on Elliot wave analysis.
• Create custom charts with active trading tools.