Thursday, September 27th, 2012 @ 10:57AM

In This Issue:

QE3 and Thee
But Will It Work?

The Unemployment Dilemma

There Are Some Economic Bright Spots

What Happened To Inflation?

The Bottom Line

The Fed slipped a skyrocket under the stock market earlier this month when it announced QE3. Although the new stimulus program had been expected, not many thought it would be open-ended. Unlike its predecessors, the new money blitz has no spending limit or cutoff date. Instead, the government plans to spend $40 billion a month on mortgage-backed securities until the unemployment rate comes down to some unspecified level.

Investors reacted immediately to the Fed’s announcement by pushing stock prices up another few notches. Additional gains continued to come in for several days. When the closing bell rang on September 26, the Dow and the Nasdaq were up 3.2% and 1.5% for the month. The “tortoise rally” we wrote about last time had turned into a rabbit run.

QE3 and Thee

One of the Fed’s goals with QE3 is to give the housing market a boost by pushing down mortgage rates. Since a healthy housing industry, along with its associated industries, can be nearly 10% of the economy, the Fed’s intentions are sound.

In practice, however, the lower mortgage rates that QE3 may create are likely to remain on paper. Loan rates are already well below 4% but it is difficult to find a homeowner who qualifies for them. Banks are far too nervous about getting into trouble again to give their best terms to anyone who doesn’t have a near-perfect credit record, and who doesn’t have a substantial down payment.

Nevertheless, the Fed’s actions will have a big impact on the profits of lenders who will pay less for the money they do put out. As a result, many bank stocks soared when QE3 was announced.

Wells Fargo (WFC) and JP Morgan (JPM) rose 3.6% and 6% respectively. Bank of America (BAC) and Citigroup (C) each made 8% gains. If the housing market continues to crawl out of the cellar, as we expect, the banks should see their stocks climb higher in the coming months.

On the negative side, QE3 puts further downward pressure on interest rates for bonds, CDs, and other fixed income investments. That’s certainly not good news for people who rely upon interest rate returns for the income they need.

But Will It Work?

The biggest question that hangs in the air after QE3 was announced is, will it have a useful impact on the weak economy?

As much as we would like to answer in the positive, the record suggests otherwise. The economy continued to slip while QE1 and QE2 were in effect. Although its successor will be larger by far, it is still the same type of pump priming program.

We will stick to our opinion we shared with you several months ago that the government can stimulate a slow but basically healthy economy but not fix one that is suffering from structural damage.

The Unemployment Dilemma

The biggest structural problem with the U.S. economy is widely thought to be a lack of jobs. But that’s not the case. There are currently over 3 million job openings, and employers have been beating the bushes trying to fill them. Unfortunately, workers with the necessary skills are in short supply. The result is persistently high unemployment.

It used to be that people with high school educations had enough basic knowledge to quickly learn to do most jobs. Any additional capabilities they needed could be provided by their employers. That’s much less true today in our complex economy.

Modern factories, for example, are often so automated that only one or two people are needed to keep everything running. Those people must have extraordinary skills that often include math capabilities that few college grads possess. The new manufacturing wizards also need to know advanced machine programming and other specialized skills. Very few high schools teach what is needed, and neither do most community colleges.

The brightest light on the employment horizon is coming from Germany where companies have their own schools to train the workers they need. The programs are expensive, but they are helping to make Germany one of the few European economies with a growing economy. Many U.S. companies are scrambling to implement similar in-house facilities.

When we see substantial federal assistance for employers who set up advanced technical training programs here, we will be more optimistic about seeing America’s unemployment rate come down.

There Are Some Economic Bright Spots

U.S. economic growth has been slipping all year. From a 2.8% annualized rate in the forth quarter of 2011, growth fell to 2.0% in the first quarter of this year, and 1.7% in the second quarter. It’s no wonder that the Fed launched QE3 even though it is unlikely to be the elixir that many people expect.

Despite the slowing economy, the long-suffering housing industry is continuing to claw its way out of the basement. The two housing stocks we recommended in February – Lennar (LEN) and Equity Residential (EQR) — are both rising. We think the trend will continue, perhaps for several years.

Lennar is doing especially well. http://finance.yahoo.com/q/bc?s=LEN+Basic+Chart The company wisely used the housing downturn to invest in distressed properties. Now the value of those properties is increasing. With real estate prices continuing to remain low in most parts of the U.S., we think the distressed investment business will remain profitable for several more years.

In addition, Lennar purchased properties in several parts of the U.S. where real estate remained in relatively good shape. Two such areas were Portland and Seattle. The value of those properties is also rising significantly.

When we purchased Lennar it was selling for $22.45. The stock is now $37.40, giving us a 67% gain for the seven month period. Because the housing rebound is still in its infancy, we think Lennar has much further to go.

We also recommended Equity Residential in February, an REIT that owns and operates upscale apartment buildings that appeal to successful professionals. http://finance.yahoo.com/q/pr?s=EQR+Profile

Equity Residential looks good to us because it focuses on higher end growth markets where rents are near the top of the scale, and vacancies are near the bottom. Properties include such landmarks as Trump Place in NYC, Harbor Steps in Seattle, City Pointe in Los Angeles, and West End in Boston – to name only a few. In total, the company owns 579 developments in 24 states.

Equity Residential is only up 3% for us, from $56.08 to $57.76, but we continue to think it will be a top-performer longer term. In addition to the capital gains we expect, this REIT pays an attractive 2.40% dividend. That’s nearly twice what Uncle Sam offers on his 10-year bonds.

Over the long term, Wells Fargo may do the best of all. As we mentioned a minute ago, the banking industry will benefit from QE3, which is why their stocks shot up after the Fed’s announcement. http://finance.yahoo.com/q/pr?s=WFC+Profile As America’s largest home mortgage lender, Wells Fargo should be in the catbird’s seat as the housing industry continues to recover. It won’t happen quickly, but we think patient investors will see excellent returns.

What Happened To Inflation?

Ever since the Fed started to pump money into the economy to prevent the Great Recession from becoming something much worse, many economists have been predicting the program would trigger another inflation cycle. However, it hasn’t happened.

We think the reason the flood of money from Washington didn’t push prices up is because most of the funds simply replaced what the recession was taking away. Every personal bankruptcy, every home price decline, and every business failure effectively destroyed enormous amounts of money. The Fed was barely able to keep up with the outflow.

In addition, a great deal of the Fed’s stimulus money went to the banks – and there it remains. The funds won’t flow into the economy until confidence in the future returns and the demand for money starts to pick up. When it happens, we can expect to see rising inflation appear at the same time.

It’s ironic, but an economic recovery is likely to bring back a problem that killed many of its predecessors, and it could happen again. We live in interesting times.

The Bottom Line

The Fed’s new QE3 stimulus program will be larger than most investors expected. As a result, when it was announced there was a rush to buy stocks, and prices rose across the board.

We don’t know how long the rally will last, but we doubt that it will have long legs. That’s because QE3 is unlikely to have a much greater effect on the economy than did its predecessors.

Nevertheless, QE3 should improve the outlook for some sectors of the economy. One of them is the housing industry. We think Lennar and Equity Residential are particularly promising. Home mortgage lender, Wells Fargo should also see its profits rise.

Until Next Time

The AIA “Advocate For Absolute Returns”, a publication of The Association for Investor Awareness, Inc., tracks market trends, industry news, the SEC, global trade and finance and Washington developments for you because they affect your investments. But who doesn’t? Many sources report these issues as abstract facts. We feel that’s not enough. The AIA Advocate’s job is to warn you of what’s important and how these developments translate to ground-level forces and threats that directly affect your wealth as well as your current investment opportunities. Not just information, but information you can use. Until next time…

Posted by AIA Research & Editorial Staff
Categories: AIA Newsletter