The big event on the agenda for investors this week was the Federal Reserve’s Open Market Committee (FOMC) meeting, which concluded this afternoon with a rare public appearance by Fed Chairman Ben Bernanke.

In effort to promote transparency about Fed policy, Gentle Ben has decided to come out from behind the curtain with his first post-meeting press conference to provide more detail about the Fed’s monetary policy stance going forward.

There were no stunning revelations … after all, these guys are economists. But this briefing could not have come at a better time.

Recently, THE hot topic of conversation in investment circles has been: What happens after QE2?

Investors will carefully study Bernanke’s comments for any clues, but there are no easy answers. At Banyan, we have our own views about life after QE2 — but more on that in a moment ...

First, a brief recap: Late last year, the Fed announced a new initiative to pump more liquidity into the financial system, with a second round of quantitative easing (QE2). The plan was to purchase $600 billion in additional US Treasury securities between November 2010 and June 2011. The “official” intent was to keep interest rates low and help nudge the economy along the path toward a self-sustaining recovery.¹

In reality, QE2 seems to have encouraged more risk-taking in financial markets, rather than promoting growth in the real economy, which was already improving before QE2.

In addition, rather than declining as many expected, interest rates on longer-term Treasury bonds have risen during the period of QE2. However, you could make the case that interest rates could be even higher without those Treasury purchases.

QE2 will likely end on schedule in June and with politics in Washington more partisan than ever, we think it’s very unlikely you’ll hear anything about QE3.

So what does this mean for markets ... and more important ... for your own investment strategy?

First, the US economy is clearly stronger now than this time last year, when worries about a potential double-dip recession spooked markets. Although the unemployment rate is still unusually high for this point in a recovery, the jobs picture is steadily improving.

Meanwhile, consumer spending has picked up, business investment continues to be strong and corporate profits are expanding at a healthy clip. On the other hand, high and rising oil prices, the prospect for deep government spending cuts and the end of easy-money policies are all new concerns investors must face.

How do we expect this to play out in financial markets?

It’s doubtful that QE2 had much ... if anything ... to do with the continuing economic recovery, but the outlook has improved just the same. However, as this expansion matures, it’s natural to expect a slowing in the growth rate of the economy and corporate profits. This doesn’t mean the next recession is just around the corner, it’s just a normal part of a maturing business cycle.

Historically, recessions are brought on by aggressive monetary tightening. And although we anticipate QE2 ending on schedule, we believe the Fed is hardly prepared to start raising rates in any meaningful way anytime soon.

Just the same, the end of QE2 will mean less liquidity, so interest rates may naturally drift higher in the absence of the US Treasury, as the buyer of last resort.

Here are a few key indicators to keep an eye on:

#1: Money Supply. Broad money growth has been picking up recently. This is certainly due in part to QE2, but it also has a lot to do with the natural pickup in commercial bank lending as the economy improves.²

But if measures of money supply growth and lending were to suddenly reverse course and decline sharply in the months ahead, it could be a red flag for the economy.

#2: Commodity Prices. There has been a strong positive correlation between Fed asset purchases as a result of QE2 and increasing commodity prices. As the US dollar sinks in value as a byproduct of QE2, commodities, especially oil, have soared. Of course, there’s a negative correlation of higher oil prices leading to lower consumer spending, so this relationship bears close watching.

This week, oil prices moved above $113 a barrel to the highest level in nearly three years. If oil prices keep surging higher and remain elevated for an extended period, it could be another red flag.³

#3: Stock Market in Transition. Last week (Inflation on the Rise? Five Sectors Set to Thrive), I briefed you on how Banyan Partners is shifting our asset allocation as the business cycle matures. Being in the right sectors of the market at the right time can make a huge difference in your bottom-line investment results. So here are some additional insights you may want to keep in mind now.

The bull market in stocks that began in March 2009 is just over two years old and may be in the midst of a subtle transition ... or consolidation phase. This could mean higher volatility in the months ahead as we see a shift in leadership among stock market sectors.

Keep in mind that every business cycle is somewhat different, but history suggests that as we work through this market transition, it could make sense to consider increasing your allocation to non-cyclical sectors, like consumer staples and health care, for example.

The graph below shows the stark difference in performance among the ten market sectors before and after a Federal Reserve interest rate hike.

As I mentioned, we don’t expect the Fed to raise rates soon. In fact, the chances of a rate hike before March 2012 have fallen to just 46 percent, according to Bloomberg.⁴

But it pays to prepare your portfolio well ahead of time for what could be in store next for markets.

You can see for yourself the big swings in performance that historically have taken place among different sectors as the market transitioned from easy to tighter monetary policy.

The graph shows you the average sector return (relative to the S&P 500 Index) during this transition in two time frames: six months prior to the first Fed rate increase (green bars) ... and six months afterward (red bars). This covers the last seven US interest rate cycles, so the data stretches back over several decades.⁵

The energy sector, for example, has gone from being the best performing sector relative to the S&P 500 prior to a Fed rate hike (+8.4 percent on average) to a negative average return (-1.3 percent) in the six months following the first rate hike.⁶

Among the best performing sectors, BOTH before and after the Fed makes its first tightening move: Health care and consumer staples were the ONLY sectors to post positive relative performance — on average — over this entire transition cycle (both pre- and post rate hike).

How about one year after the first Fed rate hike? Although not shown here, historically, the telecommunications sector posted the best performance relative to the market (+5.5 percent), followed closely by staples (+5.2 percent) and health care (+4.1 percent). Meanwhile, consumer discretionary stocks performed the worst (-9.2 percent), on average.⁷

Granted, every economic cycle is unique, and other factors can certainly influence market results, but you can see from this review that stock market leadership can shift dramatically as bull markets mature.

Bottom line: It pays to be proactive, making every effort to stay ahead of the curve when stock market leadership is in transition.

The goal of our core investment approach at Banyan Partners is to stay a step ahead of changing market conditions. Within your own stock portfolio, keep watch for subtle changes in relative sector strength, as we do. And be ready to shift your allocation for the next stage of this market cycle.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

P.S. For more details about our proactive investment approach and the asset allocation moves we’re making now, go here for a complimentary copy of our just-published quarterly outlook letter.

The opinions expressed in this newsletter are subject to change without notice and do not represent a complete analysis of every material fact with respect to any company, industry or sector mentioned in this report. The strategies mentioned may not be suitable for all investors. This information has been prepared solely for information purposes and is not a solicitation or an offer to buy a security, instrument, or to participate in any trading strategy.

¹ Bloomberg: US 10-Year Yields Reach One-Month Low as Fed Convenes, 4/26/11
² Federal Reserve Bank of St. Louis Economic Research, 4/26/11
³ Bloomberg: Oil Trades Near 31-Month High, 4/26/11
⁴ Bloomberg: US 10-Year Yields Reach One-Month Low as Fed Convenes, 4/26/11
⁵ BCA Research: US Equity Strategy, 4/25/11
⁶ Ibid.