Why would anyone be the slightest bit bullish in this yucky environment?

With a nod to a famous luxury liner named after Queen Elizabeth, it’s a little something you might call QE 2. The letters stand for "quantitative easing," the strategy now being deployed by the Federal Reserve to attack the credit crisis after everything other tactic has failed. The number stands for the fact that this is really only the second time in history it’s been tried in a meaningful way; the first was in Japan in 2001.

You may recall from Econ 101 class that central banks pursue their mission to stabilize a nation’s money supply and promote economic growth in two ways: Changing the price of money via interest-rate cuts, or changing the quantity of money by printing it. Usually they pull the interest-rate lever, but in rare cases when rates approach zero, central banks turn to quantitative channels to deliver economic stimulus.

To deliver monetary stimulus at the "zero bound," as the economists say, central bankers have theorized in their ivory towers about using an array of weapons — everything from printing money to buying toxic assets and issuing new kinds of guaranteed debt.

Well this time, the Fed fancies itself staffed by superheroes who will use both of those tactics and more. It has already cooked up almost a dozen ways to create money from thin air to make $7 trillion in commitments.

The big idea is that low interest rates don’t do much good if banks won’t lend money out to companies, and it really doesn’t do any good if companies don’t have the appetite to borrow because they’re afraid they can’t get good returns on their investments. What happens is that money…

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…just sits in the bank vaults, and has none of the sort of velocity that creates economic growth.

The Fed believes it can speed up the velocity of money by playing the role of private industry for awhile — investing in banks, buying credit and providing loans at extremely low rates. Fed governors believe this process the economists call "intermediation" — I would call it intervention — should just be a stopgap measure until the financial system gets back on its feet and deflation fears subside.

Is it a good idea? Well, the market decided over the past week that this might work, that’s part of the reason stocks rallied. One of bulls’ main arguments is that a flood of money has never failed to rejuvenate the economy, and that if you don’t buy now to the full extent of your capacity you will miss out.

As you might expect, however, I think there’s reason to be skeptical. It didn’t work in Japan in part because prolonged recession gutted the demand for money. The problem here might be a little different: Americans are going to want to see instant success for all this spending, and if it doesn’t start to show up in earnings growth quickly — and I mean, by the start of the next quarter — then I think investors will get upset, decide the plan was a big waste of money, and sell stocks heavily.

In short, optimism that the Fed’s plan will work is going to reach its apex soon, if not right away. And you know what happens when expectations get out of whack.
My best-case scenario in the QE 2 world is that a big range trade develops now with a top around the 1,050 to 1,250 level of the S&P 500 and the bottom around the autumn lows of 750 to 850.

To move higher, the trillions of dollars of federal dollars flooding into the financial system has to find traction at banks, be loaned out, get turned into corporate plant and employment expansion and hiring, and from there into consumer wealth growth. To move lower…

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… we’ll probably have to see some sort of shock such as major corporate bond defaults or bankruptcies, a retail season that is more disastrous than expected, sharp declines in earnings expectations and an abrupt increase in layoffs.

Either way, I see the next few years as a process in which all asset values — stocks, bonds, commodities, land — adjust to a level that is sustainable in a world of lower debt and lower growth.

Earnings Estimates Too High?

Over the next week, we might start to hear the holiday season is going at retail. We may be surprised to hear it’s going a bit better than the most dire projections, which might help to keep investors in a generous mood.

But pretty soon it’s going to be time to start thinking about the full quarter, and whether companies are on track to meet earnings expectations now and next year. This is where the rubber meets the road. So let’s take a quick look at consensus beliefs.

The growth rate for the fiscal third quarter of this year came in at -18.7%. While that’s clearly bad, you can see why the market tumbled so sharply this fall when you realize that on April 1 the estimated growth rate for Q3 2008 was 17.3%! That’s a delta of 35 percentage points.

Even on July 1, estimates called for growth of 12.3%. And as recently as October 1 expectations were that companies would contract by -4.3%. So you can see that expectations were incredibly off base earlier this year, and never actually caught up to the misery actually experienced at companies. (Most of the difference was the extreme weakness in financial companies.)

So what about now?

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Analysts’ estimates remain too high, in my opinion — and disappointment is likely to play a role in stocks early next year much as they did in October and November.

To get outside clarity on this issue, I’ve turned to independent credit analyst Brian Reynolds at WJB Capital. He points out that the consensus estimate for all stocks in the S&P 500 is $87 for this year and $93 for next year. Yet the S&P has actually only earned $46.10 per share in the past four quarters. To get to $87, all corporate write-offs would have to stop and the economy would have to improve enough to get back to peak earnings. Yet since peak earnings were aided by huge buyback programs created with leverage, it’s going to be at least a few years before those levels are hit again.

So if you get real crazy and say earnings growth could be 20% next year as bank write-offs are eclipsed, it implies that the S&P 500 could show $56 in EPS. Slap the current index average PE of 15.5 on that number and you get a year-end 2009 projection of 868 for the index, about 30 points lower than today.

If you think earnings will struggle amid tough credit conditions and recession, pushing the aggregate estimate to $50 and the average index company’s PE to around 13, then you get a projection of 650, or around 25% lower than the current quote.

At this point, we’re just playing with numbers, but the exercise provides us with some guideposts. To even move back to August levels, around 1,250, we would have to see earnings rise 30% over the next year to $60 and the average PE multiple go to 21.

That’s a tough bet.

To learn how to trade in this environment, check out my Trader’s Advantage letter.

This article was written by Jon Markman, contributor to InvestorPlace Media. For more actionable insights likes this, visit www.InvestorPlace.com.