The greatest trick the devil ever pulled was convincing the world he didn’t exist.” – Keyser Söze, from the 1995 film “The Usual Suspects”

When censors first sat down and watched the movie Psycho, they deemed it to be too violent.  In response, Hitchcock reviewed with them the violent scenes frame-by-frame.  To their amazement, there was no violence shown, it was all implied.  Just as the movie-going audience could imagine violence and horror at levels far beyond what actually existed, so now does investor psychology run amuck as it pertains to QE∞.

QE∞, or “infinite quantitative easing,” is Wall Street’s most recent contribution to the financial lexicon.  It refers to the Federal Reserve’s latest strategy to boost the markets by turning their virtual printing presses on and buying bonds, in the hope of creating jobs.  This is a policy derided by many economic purists, but celebrated by speculators and investors alike with the excitement of a Hitchcock psychological thriller.

The Federal Reserve, along with their European counterpart, is attempting to defy the course of history.  Central banks, by suggesting an infinite printing press and using such words as “unlimited” and “open-ended” to describe their recently expanded efforts, hope to not only remove the risk of a bank or country failure, but to fire up economic growth in the face of this increasingly sluggish economic environment.   History suggests this will prove to be a very difficult task.

The problem with implementing QE∞ is that the effective dose is unknown and each successive dosing has had a diminishing effect.  Thus far, despite global central bank efforts to buy up government bonds around the world (the Federal Reserve alone, for instance, has purchased 77% of all Treasury issuance in 2012), their theory has failed to boost the lackluster employment market.  By contrast, in the real world, the highly anticipated iPhone 5 is widely expected to boost the US economy by more than this latest round of unlimited QE.

Meanwhile, basic elementary fundamentals strongly suggest that when a central bank tries to prolong an exhausted economic cycle, inflation will eventually appear, with or without economic growth.  There is a circular reason we can’t just print a million dollars for every man, woman and child, hand it to them and fix everything – and that reason is “too many dollars chasing too few goods” – or inflation.

That said, with economic growth slowing again, Bernanke has decided to go “all in” and take a leap of faith that the third time will be a charm.  But unlike Caesar, whose irrevocable commitment to cross the Rubicon in 49BC led to victory, we think Bernanke may be just an academic general still fighting the last war.  Why?

The first two rounds of quantitative easing fuelled a surge in commodities, both in energy prices and food costs.  Several decades ago, central bank policy focus on creating “easy money” would generally drive up the price of stocks, but not commodities.  Today, with the advent of new financial products (ETF’s), investors can gain access and readily trade commodities the way they trade stocks.  The result is a much tighter relationship between stocks and commodities as prices now rise and fall in lock step like never before.

In effect, this means that energy and food prices act as interest rates used to, discouraging consumption even as the Federal Reserve believes it is stimulating the economy.  We think Bernanke’s third attempt may end up being counterproductive, particularly as oil and food prices now have the potential to surge to levels that have acted as a tipping point for the global economy in the past.  Perversely, ordering a full retreat from QE∞ would likely lead to a fall in oil and food prices and act as a significant tax cut for the middle class, thus stimulating the real economy.

While Sand Hill does not wish to underestimate a central bank’s ability to print money into infinity, we now believe we are entering a “payback” period for the excesses of the recent past.  Specifically, this means we are entering a period of positive but lower economic growth, as well as a lower return environment as the economic cycle matures, monetary policy measures become less effective, and economic stimulus measures expire.

The reality is economies accumulate macroeconomic risks over long periods and along the way markets frequently anticipate crises prematurely and incorrectly.  The stock market and the economy are “cousins not siblings” as the old Wall Street saw goes; they are not always closely linked in the here and now.  Given the effect that QE∞ is having on the markets, and in recognition of the recently failed Facebook IPO, perhaps that historic relationship should now be described as “just friends.”

Despite the fact that the markets responded enthusiastically and much like Pavlovian dogs to this latest round of liquidity, Sand Hill is staying disciplined with its macroeconomic investment framework.  This means that we are actually reducing the risk profile in your portfolio right now.  It also means that in an environment where central banks want to deliberately create inflation to drive economic growth, portfolio positioning must account for such policies.  Commodity exposure and inflation exposure in general will play an increasingly important role in portfolios going forward.  As always, we are maneuvering to anticipate and adapt to an  ever-changing environment.

It is said that art imitates life.  History, psychology and philosophy play important interdisciplinary roles in the study of art – and of the capital markets.  In that framework, QE∞ is perhaps best viewed as the latest painting to hang in the avant-garde wing of the increasingly antiquated “Museum of Keynesian Economic Theory.”  Some people love it, others hate it.  Our job as your advisor is to accept the economic reality of Bernanke’s latest work, and to remind ourselves that if the devil does exist, its name will ultimately be Inflation.