This week, QE2 has been hard to miss: even the most mundane traffic news was invariably peppered with proclamations of impending QE2 or the lack of thereof. With QE2 on everyone’s minds, not the cruise ship, but the much more mundane variety, is of course the second iteration of the so-called “quantitative easing,” so named and proposed by Ben Bernanke, the Chairman of the U.S. Fed. Some commentators suggested that QE2 is a positive development, while others degraded QE2 as detrimental to investors. This article looks at the “hard numbers” behind the QE2: the quantitative effects on the U.S. equity markets.

Despite its highly quantitative name, the process of quantitative easing really refers to an expansion of the U.S. Fed Balance Sheet in order to use the money to prop up the U.S. government debt. It is understood that buying up the U.S. Treasury offerings on the secondary market, in turn, artificially lowers the U.S. interest rates in an effort to stimulate the U.S. economy.

Figure 1 shows the cumulative changes in the U.S. Fed Balance Sheet (less Reserve Bank Credit) reported by the U.S. Fed, and the cumulative changes in the S&P 500 over the same period. A couple of interesting points emerge out of the chart: if the S&P 500 reacts to changes in the U.S. Fed Balance Sheet, it reacts more to the expectations of the changes than to the changes themselves. For example, going into the November election cycle, the U.S. Fed talked about QE2, while implementing little of it, yet still rousing the U.S. markets.

Quantitative studies on the impact of expansions of the U.S. Fed Balance Sheet on various equities confirm this observation: most stocks that predictably respond to increases and decreases in the U.S. Fed Balance Sheet, do so prior to the announcement of actual changes to the Balance Sheet, supporting the “buy on rumor, sell on fact” investing styles. Yet, investors wanting more certainty can hold off until after a balance sheet announcement is made: a selected group of equities tends to respond with a 99.9% probability to expansions and contractions of the Fed’s Balance Sheet AFTER the changes to the Balance Sheet are announced.

In particular, healthcare stocks tend to rise following quantitative easing decisions. Companies like Aetna Inc. (AET), Cigna Corporation (CI), Covidienplc (COV), Quest Diagnostics Incorporated (DGX), United Healthcare Group (UNH), Wellpoint (WLP), and the healthcare sector ETF (XLV) consistently rise after the announcement of the Balance Sheet expansion is made, as do selected technology companies like IBM (IBM), Microsoft (MSFT), and Rambus Inc. (RMBS). Retailers and grocers also appreciate in response to increases in the Balance Sheet (notable examples include The Kroger Co.: KR, Supervalu Inc.: SVU, and Safeway Inc.: SWY).

Figure 2 shows the magnitude and the probability of the response of Aetna (AET) to increases in the Balance Sheet less the amount the Fed allocates to the U.S. Bank Reserve. On average, the U.S. Fed Balance Sheet, changes by US$6.45B (up or down). Following an extension of the Fed Balance Sheet, AET rises over the next four trading days by 0.12% per every $1B expansion announced with probability approaching certainty. Similarly, when a contraction of the Balance Sheet is announced, AET falls with equal probability by 0.12% per every $1B reduction in the size of the Fed Balance Sheet.

To be safe when investing on QE2 and other Balance Sheet expansions and contractions, investors should wait for the actual announcement and then place the trades on stocks like AET, that consistently respond to the changes in the balance sheet post-announcement.

Irene Aldridge is a quantitative portfolio manager at ABLE Alpha Trading, LTD. She is also a co-author of the Quant Investor’s Almanac 2011: A Roadmap to Investing (Wiley, 2010), an up-to-the-minute compendium of economic announcements upcoming in 2011, and a summary of responses of various equities, foreign exchange and other securities to different economic announcements.

This entry was posted on Thursday, November 18th, 2010 at 4:24 pm and is filed under Quant Speak. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.