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Beware the 'Zombie Stock Market'

BEVERLY HILLS, CALIF. - The two words spoken most frequently here at the Milken Institute's annual gathering of business leaders were "cautiously optimistic." That's how a variety of CEOs and financial titans view the outlook for the economy.

But not everybody thinks the Federal Reserve's aggressive experiment with "quantitative easing" will end well. "It's a zombie stock market, pumped up on steroids," said Todd Morley, CEO of the G2 Investment Group during a panel discussion. "I just don't think it's a real market anymore."

That's an uncomfortable concept for stock-market investors, who have profited handsomely from a four-year rally in which the S&P 500 stock index has risen by nearly 100 percent. Many bond investors have profited during that time as well, as strong demand for Treasurys and other securities considered safe has driven up prices.

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The Fed's easy-money policies have been instrumental in the activity of the financial markets. Most economists agree that the extremely low interest rates engineered by Ben Bernanke and his Fed colleagues have forced investors to buy stocks, among other things, which has been one factor "reflating" stock prices after the market plunge in 2008 and 2009. The Fed has also gobbled up more than $2 trillion of bonds during the last four years, distorting a market it usually plays little role in.

The big question investors are grappling with now is what will happen once the Fed ends quantitative easing and begins to tighten its monetary policy. Many investors think (or hope) it will go more or less smoothly, with the Fed acting gradually and using a variety of tools to make sure interest rates and inflation don't rise too fast or too much. Low inflation of about 2 percent has made it easy to forget about the risk of rapidly rising prices that could destabilize markets.

But some skeptics think the Fed isn't quite that good. "I don't think the Fed will be as adept as putting the genie back in the bottle as it thinks," Morley said. "Inflation is a time bomb and when it comes, it's going to come violently."

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He points out that in the first half of 1973, inflation was tame - then it hit 7 percent in a single month. The spike came after a decade of growth in the money supply, similar to what has happened during the last few years, and inflation ravaged the economy for the rest of the 1970s.

The Fed's "exit strategy" is worrisome because nobody knows how much of the stock market's four-year rally is due to Fed policies, or how weak the economy would be without the Fed's extraordinary intervention. Optimists point out that stocks, for example, don't seem to be overvalued relative to corporate earnings, and some advisers think it's a great time to buy stocks, even four years into a rally.

Yet most prominent investors acknowledge that the Fed, even if it has genuinely aided the economy, has also created an unpredictable and perhaps even volatile investing climate. "There are distortions in the markets," said Mohamed El-Erian, CEO of the bond firm Pimco.

"Capital is being misallocated. Price signals are broken. The hope is that the visible hand of the Fed will hand off to the invisible hand of the markets and the private sector. But we live in a world where markets are very assisted by the Fed. That's why excitement is coupled with anxiety."

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One problem for worriers, though, is that it can be hard figuring out what to invest in if you don't trust the stock market. Bonds are likely to lose value if interest rates go up, and savings accounts still pay paltry interest rates. Morley says his favorite investment at the moment is the energy sector, though that too can be risky. Stock backers at the Milken conference favor strong consumer brands with global reach, well-performing financial services companies and firms able to benefit from the growth of developing countries. Where, hopefully, there are no zombies.

Rick Newman's latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.

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