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Why markets may yawn if more stimulus is unleashed

When the summer began, equity markets were clinging to hopes that central bankers would ride to their rescue. As the rally-filled summer winds down and that rescue grows increasingly likely, the question now is whether the bankers can live up to their advance billing when they arrive.

After a 12-week rally that has lifted the S&P 500 by more than 10 per cent (it closed Tuesday at 1,409.30), some market strategists believe stocks may have already fully priced in the anticipated injection of monetary stimulus from both the U.S. Federal Reserve Board and the European Central Bank. That leaves little upside for stocks if and when the stimulus programs are announced – and the prospect of a significant correction if the central banks deliver less than investors expect.

"Maybe there is too much priced in," said Stéfane Marion, chief economist and chief strategist at National Bank Financial in Montreal.

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"We believe that 1,350 is a fair price [for the S&P 500] based on the economic fundamentals," he said. "So, 1,400 represents an awful lot of central-bank muscle flexing that I'm not sure is warranted."

The prospects for a third round of quantitative easing from the Fed – long ago tabbed QE3 by the financial community – grew much stronger last week, with the release of the minutes from the most recent meeting of the Fed's monetary policy committee. The minutes indicated that "many" committee members believe "additional monetary accommodation would likely be warranted fairly soon," unless incoming economic indicators showed "substantial and sustainable strengthening in the pace of the economic recovery."

The reality of what the Fed has in mind could come as early as this Friday, when Fed Chairman Ben Bernanke addresses the high-profile Jackson Hole Economic Symposium – the same venue at which he tipped his hand on the Fed's second round of quantitative easing (QE2) in August of 2010.

Meanwhile, European Central Bank chief Mario Draghi has spent the past month hinting strongly that the ECB is preparing further monetary stimulus of its own, including buying bonds of troubled sovereign borrowers such as Spain and Italy. (Mr. Draghi on Tuesday cancelled his own scheduled address at Jackson Hole.)

"The markets are totally addicted to QE, but I think it is not only about the Fed, but what sort of bazooka the ECB is about to unload," said David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates Inc. "It has been all this speculation about QE that revived the market off the summertime lows – it certainly wasn't earnings, revenues or guidance. So a lot is priced in, to be sure – maybe even the whole rally."

But whether more quantitative easing (the buying of financial assets by central banks as a means to increase money supply) will really provide a sustained boost to economic growth and corporate profits is an open question. The benefits from previous rounds of QE from the Fed, as well as the ECB's Long-Term Refinancing Operation (LTRO) that began late last year, have proven only temporary for both stocks and the economy.

And this time around, even those fleeting gains may be hard to come by, said London-based economic and financial-market research firm Capital Economics. "We are skeptical that QE3 would have anywhere near as big an impact as QE1 or QE2," the firm's chief global economist, Julian Jessop, wrote in a report last week.

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He argued that the successes of previous rounds of QE came from reducing long-term borrowing costs and boosting the availability of corporate credit. But especially in the U.S. market, credit conditions and borrowing costs are already greatly improved from two years ago.

National Bank's Mr. Marion said the improved conditions and healthier U.S. economy will make it hard for the Fed to justify a big QE program.

"I'm not sure they can commit to a big figure," he said. "If we don't get a lot of QE, 1,400 looks too high [for the S&P 500], given the pressures coming on earnings."

Paul Ashworth, chief North American economist at Capital Economics, said it's "almost impossible" to know what level of stimulus is priced into equity markets, but he believes the market is anticipating a program in the $500-billion to $600-billion (U.S.) range. That would be about the same size as QE2.

But even if the market gets the amount it is anticipating, he said, stocks may decline. Like Mr. Marion, Mr. Ashworth sees a reasonable price for the S&P 500 being around 1,350 by year end, or about 5 per cent below current levels, as the realities of a sluggish economy and weak corporate profit growth return to the forefront.

"You're not going to get any higher from a monetary policy response," he said. "Then we'll get back to why we needed a monetary policy response in the first place."

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