You can’t blame Federal Reserve Chairman Ben Bernanke for trying. Faced with a struggling economy last summer, he devised a massive $600-billion plan to revive the economy, known as QE2 (or the second major round of quantitative easing). Investors are surely pleased, with the S&P 500 Index rising more than 20% since Labor Day. But it’s still unclear whether the plan really altered the trajectory of the U.S. economy, so investors are now faced with a more sobering backdrop for stocks.

A fresh slump
By the end of 2009, a clear consensus emerged that the U.S. economy had dodged a bullet. Major financial institutions no longer looked sickly, consumers began to spend more robustly, and gross domestic product (GDP) growth finished the year on a high note, rising 5.0% — the best quarterly showing in a number of years. Yet it soon became apparent that the economy was not yet as healthy as many had hoped. GDP growth slipped to 3.7% in the first quarter of 2010 and just 1.7% in the second quarter. Investors grew concerned. The S&P slipped from more than 1,200 in late April to about 1,020 by early July.

#-ad_banner-#Bernanke soon devised a fairly simple but powerful plan: Use the Fed‘s balance sheet to buy back $600 billion worth of bonds. The bond sellers would presumably take their proceeds and re-invest them in the economy. The ostensible goal was to spur bank lending, business spending and, most importantly, keep the economy from grinding to a halt.

Arguably, only the last goal was met. Banks retained very tight lending standards, leading many small business owners to complain about an inability to get financing. Yet the economy clearly stopped stalling. GDP growth rebounded to 2.6% in the third quarter of 2010 (though you could argue that QE2, which began in the end of that quarter, doesn’t get credit for that) and a more robust 3.1% in the fourth quarter.

These days, the sheen of QE2 has worn off. GDP growth slipped back to 1.8% in the first quarter of 2011 and signs are emerging that growth in coming quarters may be tepid as well.

Clear benefits
To be sure, QE2 has been a real boon for investors and corporate America. Though the freed up funds may not have made their way into fully productive uses, stocks surely benefited from all the fresh liquidity. The market slump last summer was replaced by a robust rally into the fall and winter — from the end of August 2010 until mid-February, the S&P rose 28%. Commodities also benefited from all of the QE2-inspired liquidity that sloshed through markets this past winter, as evidenced by rising prices on everything from oil to corn to soybeans.

The bond market has also benefited. Rates on 10-year Treasury Bills are just 3.1%, the lowest level in a year. With rates this low, corporate America issued a wave of bonds to take advantage of the cheap money. Nearly $400 billion in corporate bonds have been issued in the first five months of 2011, roughly 30% more than the same period last year, according to Dealogic. Cash-rich Google (Nasdaq: GOOG) just sold its first-ever bonds — simply because rates are so low. A recent two-year, $3 billion offering from Texas Instruments (NYSE: TXN) sports an interest rate below 1%. Talk about getting while the getting’s good…

But with the end of QE2, some chief financial officers expect borrowing costs to rise later this year.

What’s next?
Considering the still-weak state of the U.S. economy, Bernanke has no desire to suck $600 billion right out of the market by reversing all the stimulus provided by QE2. That day will come later, but you could argue that if the market strongly benefited from the Fed‘s stimulus, then it would feel a major headwind from the eventual unwinding. This may explain why the major market averages have stopped rising and are now back to levels seen in February of this year (The S&P stood at 1343 on Feb. 18, eventually rose higher and is now back to 1334). Investors look ahead, so they’re digesting the end of QE2 now in order to deal with the reversal of QE2 that will happen later. 

To be sure, by keeping interest rates at record-low levels and by stretching the Fed‘s balance sheet, Bernanke has run out of options. “The end of QE2 is high tide of easy monetary policy,” St. Louis Fed President Jamie Bullard told Bloomberg. If anything, further inflation pressures, which as of now are confined to just energy and food, may force the Fed to start raising rates. For an economy that is fighting to get on its feet, this would be unwelcome news. Minneapolis Fed President Narayana Kocherlakota recently predicted that the central bank would hike rates 50 basis points by the end of the year, though this would still leave rates below 1%. This shouldn’t be a problem for stocks per se, but as investors start to look at the interest rate trajectory in 2012, they may be less sanguine.

Action to Take –> So is a market pullback inevitable? Not necessarily. Clear positives have emerged in the economy: corporations are in very strong shape, are beginning to rebuild depleted staffs, and are increasingly finding new paths to growth in overseas markets. These factors could put a floor under stocks, but it’s also quite possible that the major market averages have seen their highs for the year and will simply tread water from here on out.

What this means is it’s becoming a “stock picker’s market.” Up until now, the theme has been a “rising tide lifts all boats,” meaning one could almost simply pick a stock and watch it rise with the overall market. And in light of the push/pull nature of the economic and corporate cross-currents, investors may continue to rotate into more defensive sectors such as consumer staples, utilities and other safe income plays. Investors may also become more reluctant to pursue “high-growth” stocks that sport very rich multiples such as Netflix (Nasdaq: NFLX), Salesforce.com (NYSE: CRM), Chipotle Mexican Grill (NYSE: CMG) and other recent highflyers.

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