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QE2: Beware the Perils of its Success

November 30, 2010

by Vitaliy Katsenelson

What should investors do? 

If the Fed “succeeds” and creates a short-term bubble in stocks and other asset classes, investors’ true time horizons and investment discipline (i.e., adherence to the investment process) will be put to the test.  Unfortunately, investors don’t have the tools to play in this Wall Street version of “looking for a bigger fool to buy your overvalued assets” game. 

As was the case with the dotcom bubble, in the giddy phase of bubble expansion ignorance is wonderful bliss and knowledge and adherence to the investment process are a curse – as disciplined investors will always sell too soon and will not partake in the bigger fool game.  However, when the bubble bursts the money will flow to its rightful owners.  The Fed doesn’t want to you to be in cash, it wants you to reach for yield and speculate – but don’t. 

In the absence of good investment opportunities, the worst thing you can do is take advice from the Fed. 

P.S. QE1 vs. QE2 – They are very different!

Modern societies have fractional reserve banking systems where for every dollar deposited in the bank, roughly 95 cents are lent out.  This system functions fine as long as a bank’s losses are manageable and depositors believe in the continuity of the banking system – in other words, they expect their deposits to be there tomorrow.  However, even in the absence of any losses, if the presumption of banking system continuity is broken and depositors fear for their funds and withdraw their money, then even the best, most conservatively run bank that has zero loan losses, will go bust.  This is a run on the bank.  Because of financial leverage, banking is one of the few industries where (false) perception may lead to reality.

The Federal Reserve System was established in 1913, following the 1907 Bankers’ Panic, a recession and collapse of several banks that led to runs on the country’s banks.  Then all-powerful JP Morgan directed a coalition of banks that backed the banking system and stopped the nationwide run.  This planted the seeds for the creation of the Fed.  The Fed’s job was to be the lender of last resort, to avoid future bank runs.  However, creating an institution that does its work only a few times a century was impractical, so the Fed was given additional responsibilities to regulate banks and to maintain stable price levels and full employment.