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Stocks don't need another dose of quantitative easing. They need the economy to be healthy enough that the Federal Reserve Board doesn't have to consider one.

Equity markets rallied midweek on growing talk that the Fed, the U.S. central bank, was considering another round of quantitative easing (QE) in light of sputtering U.S. economic indicators and growing financial-market risks out of Europe. Those hopes were dashed when first the Fed released a brighter-than-expected survey of U.S. regional economic conditions, and then Fed boss Ben Bernanke gave a speech to a U.S. Congressional committee that contained nary a hint that more QE is on the table.

The fact the stock market didn't sink on these two pieces of Fed news is, perhaps, evidence that investors are finally getting it. QE is an injection of funds into the financial system in order to stimulate economic activity; it's means to an end. What has mattered to the market all along has been not the Fed's actions, but the economic outcome.

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Stocks and QE

At a glance, it's easy to think that QE has been a key stock market catalyst over the past three years. Following the launch of all three Fed actions to date – commonly known as "QE1," "QE2" and "Operation Twist" – stocks moved decidedly upward. After the first two of those programs ended, equities declined. (The third program, Operation Twist, ends next month.)

But the stock market's upward move became less pronounced, and less sustained, with each subsequent Fed move. In 2009's QE1, the market trended strongly upward during the entire period; in 2010's QE2, stocks flattened out months before the program ended. Now, in Operation Twist, the market has turned sharply downward months before the program is due to expire.

A look at one of the market's most important economic indicators – the Institute for Supply Management's index of manufacturing activity – provides an explanation for the apparent inconsistencies in the market's behaviour surrounding the Fed's operations. The turning points for stocks very closely match those of the ISM index – in some cases flattening and turning downward along with the ISM even while the Fed was still priming the pump.

It's the economy

Were the Fed operations themselves the spark for the rebounds in the ISM manufacturing numbers that roughly coincided with the QE periods? Supporters of QE (including Mr. Bernanke) believe they were. Critics of the policy say monetary easing doesn't work that quickly or directly, that the economic bounce was a convenient coincidence.

Regardless, the data suggest the stock market's response had much more to do with the subsequent economic activity than with the monetary policy itself. In the short term, QE actions may calm investor fears and ease their risk aversion, but ultimately those rallies only go as far as the economy carries them.

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