Add This Powerful Market Anomaly to Your QE3 Playbook

Published Tue, Aug 28th, 2012   Matthew Weinschenk, Senior Analyst

The market is waiting for news of a third round of quantitative easing to come out of the Fed’s meetings in Jackson Hole this week.

If it doesn’t happen on Friday, all eyes will turn to the Fed’s Open Market Committee (FOMC) meetings on September 13 and 14.

Either way, the expectations are that the Fed will offer some sort of increase in the money supply to counter stagnant employment numbers that threaten to lead us into a double-dip recession. Bill Gross puts the odds at 80%.

To book gains on QE3, however, you need to know two things: The best time to place your bets and where to invest to pocket the biggest returns.

Let’s start with timing…

The Best Time to Cash-in on QE

Cashing-in on QE3 starts with understanding equity risk premium.

This is the return that stocks provide over the return on bonds. In other words, it’s the extra return you get for taking risks with stocks, rather than investing in the safety of bonds.

So what does this have to do with the Fed?

Well, it turns out there’s a significant anomaly associated with equity risk premium and the timing of FOMC meetings.

You see, the premium is normally around 8%. Meaning that you’d make 8% more on average with stocks over bonds.

What’s intriguing, though, is that around 80% of this premium is generated during the 24 hours leading up to an FOMC announcement. 80%!

To put it another way, if you completely removed these FOMC announcements from the equation, your stocks would only return 1.6% more than risk-free bonds.

A paper released last month by the Federal Reserve Bank of New York confirms these findings. The research shows that if you were to step out of the market just before FOMC-related announcements, your returns would be drastically lower.

The simple lesson here: The Fed has the ability to move the market before it even says a word.

And that brings me to the second part of profiting from any further quantitative easing – the specific markets that get the biggest boost.

For the Best FOMC-Related Gains, Look Outside the United States

The Fed has a simple goal when it comes to monetary easing: Provide a temporary boost to our economy and that, in turn, boosts our stock market.

The biggest gains, however, aren’t seen in the United States, but halfway around the world…

Indeed, the biggest gains from changes to the U.S. monetary policy can be found in emerging markets stocks.

As you can see in the chart, when the Fed opens the spigots, stocks in emerging markets surge higher.

Of course, this activity isn’t a direct result of the Fed’s decision. After all, the money the Fed creates doesn’t go to developing countries.

The uptick isn’t caused by fears of inflation driving investors to international markets, either (as some inflation hawks would claim).

The simple fact is, emerging markets move with the “risk-on, risk-off” trade that’s dominated the market for the last few years. Meaning investors either want to buy risky assets – or they don’t – and all investments shift because of it.

So when the Fed eases, the global economic outlook looks better. That, in turn, makes risky investments (like emerging markets) much more attractive.

History shows that if the Fed unveils a substantial QE strategy, you should expect about nine months of emerging markets gains. But again, based on the data above, you should stay in the market throughout the days leading up to Bernanke’s announcement, too. Don’t just try to jump in after the fact.

And who knows? Maybe the Fed’s decision will make a real impact on our job market this time, as well.

Ahead of the tape,

Matthew Weinschenk