How to Trade the End of 'QE2': Strategists

NEW YORK ( TheStreet) -- Quantitative easing, which has kept yields on bonds artificially low and has investors flocking to risky assets such as stocks and commodities, is widely expected to end in June.

But market analysts say investors should continue to bet on stocks and commodities even after the Federal Reserve ends its $600 billion bond-buying program -- known as QE2 -- as bonds will prove to be an unsafe alternative.

A combination of recovery expectations, inflation risks and worries about the massive federal deficit have been pressuring bonds and lifting yields -- bond prices and yields share an inverse relationship. But with the Fed stepping in to buy up Treasury notes, analysts say the rise in yields has been relatively modest. The intention of the Fed's purchases is to dampen interest rates, so as not to threaten an economic rebound.

However, once QE2 ends, bonds could sell off further, causing yields to climb higher. And the central bank might be forced to hike short-term interest rates eventually, as economic growth returns and inflation spikes, hurting bonds further and making them an unsafe investment for investors.

The biggest bear signal for bonds yet came last month, when Bill Gross, renowned manager of the world's largest bond fund at Pimco, exited Treasuries and increased his holdings in cash.

While rising interest rates would normally pose a threat to stocks, analysts say that is not an issue in the near term. With the federal funds rate near zero, it would take a significant monetary tightening to dim the attractiveness of stocks.

James Dailey, chief investment officer of TEAM Financial Managers, expects central banks across the world to be slow to raise rates, making commodities and commodity-related stocks a good bet even after QE2 ends.

"The damage has been done. We have seen a pickup in the inflation cycle," said Dailey. "It is not just the Fed pressing the accelerator. It is the Bank of Japan and the European Central bank. I don't think there is going to be any draconian tightening anywhere."

"Even if we see tightening, that is no reason to not own commodities," he added. "Central banks will be behind the curve. You can get corrections based on it being overbought now but the fundamentals are intact. Unless there is a global recession or one or more central banks find religion and develop a Volckeresque appetite for monetary tightening, we see negative real yields."

Dailey says he favors commodity-related stocks in the agriculture, energy and precious metals space. "Energy stocks are going nuts right now but they are still pricing in $90 oil. So even if oil plateaus at this level near $108 levels, those stocks are cheap."

The analyst also prefers blue-chip names that are trading at low valuations such as Microsoft ( MSFT), Dell ( DELL) and Hewlett-Packard ( HPQ) as well as consumer companies such as Wal-Mart ( WMT) and Procter & Gamble ( PG) that might be better placed to pass along higher input costs.

He is relatively less bullish on industrials such as Caterpillar ( CAT) and Deere ( DE). "Those stocks have largely priced in the optimism. Valuations are risky and are based on the premise that profit margins will stay high," said Dailey.

While Dailey expects selective stocks to do well post-QE2, Phil Orlando of Federated Investors says an end to QE2 in June would be positive for stocks overall. "The market is going to rip on the idea that the Fed is starting to normalize policy after three years. It will tell investors that the Fed is confident about the economy sustaining itself on its own. And stocks are cheap."

Orlando is bullish on stocks that are leveraged to global growth -- tech, financials and energy, while he recommends de-emphasizing low-growth sectors such as utilities, consumer staples and health care.
Federal Reserve Chairman Ben Bernanke

QE2 also triggered a search for higher-yielding securities, making dividend-yielding stocks a universal favorite for analysts. That may not change in the post-QE2 world either. Investors looking for cash flow might have no other alternative outside of dividend-yielding stocks as traditional fixed income investments have little to offer.

"It is a strong term but the immorality of the Fed's policy is that it has removed safe-yielding investments," says Dailey. "We have tried to generate cash flow in the overall portfolio through REITs like Annaly Capital ( NLY) and Redwood Trust ( RWT). Yields are much higher and their dividends are safe."

Gold is also expected to do well as the end of QE2 is unlikely to put inflation worries and concerns about the fiscal deficit to rest. Investors are worried that the government will postpone making tough decisions on spending to after the elections and would continue to resort to policies that weaken the dollar. "I don't see any policy alternative out of Washington outside of inflation," said Dailey.

John Mauldin, president of Millenium Wave Advisors, says he continues to buy gold for protection as the market could still suffer from exogenous shocks such as the sovereign debt crises in Europe or a slowdown in Japan.

"I am buying gold every month. Not because I am a gold bug. But after what I have seen in the last few weeks, and I have been talking to political leaders, it's making me very nervous," Mauldin says, referring to the political stalemate over the budget issue.

>>>Q&A with Millenium Wave's John Maudlin

"Gold is not an investment for me, you understand," he continues. "It is something I need to buy because I want something sitting in my vault if things go wrong. It's insurance."

--Written by Shanthi Bharatwaj in New York.

Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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