An investing maxim, when turned on its head, can still be true. In decades past, investors were told that you “can’t fight the Fed,” which meant that when the Federal Reserve was boosting interest rates, markets would be hard-pressed to rally. 

These days, that adage has a whole new meaning. The series of quantitative easing (QE) measures appear to be a huge factor behind our steadily-rising markets, and anyone fighting the liquidity the Fed has delivered has been on the wrong side of the trade. 

#-ad_banner-#The Fed’s efforts have propelled all assets higher, creating real pain for short sellers and other market bears. Look for more of the same in coming months. But soon thereafter, the Fed — and the market — could swiftly shift direction. 

So you need to keep an eye on the exits. 

What drives stocks?
There are two key drivers of stock prices: Corporate profits and the expansion or contraction in the perceived value of a company’s earnings streams and assets. 

Let’s break them down…

Profits are often good predictors of stocks prices and have risen about 5.5% annually during the past 35 years on an inflation-adjusted basis, according to Morgan Stanley. Stocks have done poorly right at times when profit growth is expected to slow, and stocks have rallied when profit growth is expected to accelerate.

 It’s notable that today, real earnings growth has begun to decelerate even as the market rises higher. 

Even as profit growth in the S&P 500 slowed to 6% in 2012, the index rallied an impressive 13%. And even as profit growth is expected to slow a bit more in 2013 (the consensus forecast anticipates a 5% rise in S&P 500 profits, though some strategists say we’ll see zero profit growth this year), the S&P 500 has already tacked on another 5% gain in just the first month of 2013. 

The fact that stocks are rising higher even as profit growth is slowing can be explained away by the other factor behind the market: Asset valuations. Simply put, the Fed has added a $1 trillion punch to the economy through the various QE programs, which is leading to asset price inflation.

Strategists at Morgan Stanley draw a direct line between cause and effect:

“Asset appreciation increased during QE1 and its extension, then fell (reaching 20% depreciation in August 2010); appreciation resumed during QE2, then dropped off in Summer 2011; with Twist and QE 3, appreciation resumed again. During QE2 and the first nine months of Twist, there appeared to be diminishing returns to QE (i.e., lower slopes on asset appreciation). Starting in July 2012, however, equity multiples began rising much faster. Since the start of QE3, asset appreciation has remained high – currently at 11% per year. “

Indeed since the middle of May 2012, the S&P 500 has risen 16%. That’s an annualized gain approaching 25%, even as earnings growth headwinds have materialized during the past three quarters.

Stocks haven’t been the only beneficiary of the Fed’s liquidity moves. The proceeds from asset sales to the Fed have also found their way into the commodities markets. And that’s fueled double-digit six-month gains across the board.

[Related: “Forget Gold Or Silver: This Metal Is Headed For A Classic Supply-Driven Rally”]

Of course, the Fed is hoping that the asset-boosting moves will have a stimulative effect on the economy, leading economic activity to expand and corporate profits to start rising at an accelerating pace. 

Will the Fed succeed? We’ll soon find out. Morgan Stanley’s strategists figure that “there are two or three quarters left until judgment gets passed — either the Fed is successful and EPS and the economy reaccelerate, or the market is likely to sharply correct.”

These strategists don’t even touch upon the other major risk that an aggressive Fed policy entails. Once the Fed stops supporting the economy with its QE efforts, investors will start to wonder about the effect that the eventual sale of $1 trillion in Fed-acquired bonds will have on the economy once they are put up for sale. This tidal wave of bonds coming on the market could crowd out other bond issuers, raising the cost of debt for all parties. 

Talk about “taking away the punch bowl.” This maxim may soon have a greater effect than many suspect.

It’s almost hard to grasp the size of the total QE program. Here’s a brief timeline:

•November 2008: the Fed begins to buy billions in mortgage-backed securities (MBS). By June 2010, the Fed carried $2.1 trillion in bank debt, MBS and U.S. Treasury Notes on its balance sheet.

•The Fed let that total balance drop in the summer of 2010 as bonds matured and weren’t replaced, and that negative liquidity may have played a role in the market’s 10% drop that summer.

•In November 2010, the Fed announced QE2, leading to the purchase of $600 billion in Treasury Securities by the following June.

•In September 2012, the Fed announced QE3, which called for a more modest $40 billion purchase of MBS. Those actions have again led investors to sell their MBS and other bond holdings and re-invest the proceeds into more speculative assets such as stocks. 

The sum total of QE1, QE2 and QE3? It’s hard to determine a precise accounting, but the Fed is likely holding roughly $2 trillion of assets. How this position will unwind remains a bit of a mystery. Before we even get there, some investors are wondering whether the Fed will deliver another treat in the form of QE4. But recent comments from the bank suggest that enough has been done on that front.

Instead, the focus will soon shift to gauge what will happen to stocks once the QE3 buying wraps up this spring, and the prospect of QE4 begins to fade.

Risks to Consider: Strategists note a “Wall of Worry” for good reason. That wall is built on the backs of the various QE programs, and disassembling the Fed’s bloated balance sheet will require surgical precision.

Action to Take –> This is not a call to sell all of your stocks. Indeed stocks could rally into this spring, if current momentum is any guide. Instead, it’s an early warning to book profits in some of your best investments, especially those that now trade at or above any sort of fundamental underpinning. 

It’s time to play on your heels, holding defensive stocks that tend to hold up better in tough markets. These are stocks that sport solid and defensible dividend yields, stocks that trade below book value, or at a very low multiple to cash flow. 

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