Market Bull vs. Federal Reserve Bubble

Chidem Kurdas

Two opposed views crystallized as managers discussed investment prospects at a conference this week.

What could be called the sunny view was exemplified on this occasion by Richard Bernstein, the former Merrill Lynch chief investment strategist who now has his own firm and manages two Eaton Vance funds, one in equity and the other all-asset.

He said this is one of biggest bull markets he’s encountered in his career. He’s been bullish on U.S. stocks for three-and-a-half to four years and still is; it has paid well and he sounds confident it will continue to do so.

A contrary perspective, on the darker and stormier side, was articulated by Kathleen Gaffney, a bond manager, and Eric Stein, a global macro manager, both at Eaton Vance.

Mr. Stein said Federal Reserve policy is driving asset prices, not only in the United States but worldwide. The central bank could have shifted gear in September without shocking markets but chose not to do so. Economic fundamentals have not changed much but the policy picture has altered dramatically.

The implication: What we see now is not a real bull market based on fundamentals but the result of the Fed’s continuing $85 billion monthly monetary infusion.

The bullish position is fairly straightforward—the economy is improving, long-term interest rates will go up but that’s because the economy is getting stronger, all this is similar to previous business cycles and investors are needlessly cautious.

By contrast the bearish case is complicated. If the stock market is afloat on policy-created liquidity, it depends entirely on what the Fed does next and what people expect it to do.

There is wide agreement that the next presumed Federal Reserve chair, Janet Yellen, is a dove committed to low rates to reduce unemployment. But in the meantime that policy is pushing investors into stocks and possibly blowing air into prices.

There is policy risk, said Ms.Gaffney—-the Fed under Chair Yellen may do the right thing and puncture the bubble.

That would correct the over-valuation, thereby getting rid of a threat to long-term stability. But retirement nest eggs invested in stocks would go poof.

For this part Mr. Bernstein emphasizes that Fed policy is a lagging indicator, not a leading one. That is, it reacts to the economy after the fact and reflects the past, not the future. From that angle, the Fed will act very late in the game and until then there is little danger to the stock market.

Whether high share prices reflect economic recovery or a government-created bubble, just about everybody agrees on one prognosis: expect volatility.

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