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What Happens to Stocks When Economic Stimulus Fades?

Economic stimulus has been a friend to the stock market this year, but investors are worried that the two may be parting ways in the coming months.

US Capitol Building with cash
US Capitol Building with cash

Wall Street has surfed along on a six-month wave of support generated in part on $787 billion in government stimulus that has complemented highly accommodative fiscal policy at the Federal Reserve.

But central banks both in the US and globally have indicated the party will be coming to an end soon. The Fed this month is ending its aggressive buying of Treasurys and many analysts believe that while rate increases aren't likely in the immediate term, the central bank will have to take some action in the coming months to curtail inflation.

Economist Nouriel Roubini referred to it this week as the "wall of liquidity" which could end up tumbling down on Wall Street.

"His wall of liquidity is what helped stocks. Money has to go somewhere, and many perceived that stocks had hit a ridiculous low," says Peter J. Tanous, president and director of Lynx Investment Advisory in Washington, D.C.

But now that the stock market has jumped 50 percent off its March lows, market pros are wondering what will propel it higher.

A need to curtail inflation, and its accompanying policy responses, could provide a substantial obstacle if the Fed's actions get ahead of the market's needs.

"The tightening effect that everyone is looking for six months down the road will be a reaction to the inflationary pressures that are caused by the massive deficits and the massive spending. It takes time for all the money to make its way through the economy and start affecting prices," Tanous says.

"Once it happens, the Fed has an itchy trigger finger to cut it off at the pass very quickly. Everyone is thinking they want to get ahead of the problem, not follow it."

Indeed, inflationary fears raised their head Monday in unexpected fashion.

A $7 billion auction of 10-year Treasury Inflation Protected Securities fetched a high yield of 1.51 percent. More remarkable, though, was the demand for the TIPS notes, reflected in what is known as the bid-to-cover ratio.

The ratio came in at 3.12, meaning investors bid $3.12 for every $1 auctioned off, nearly 50 percent higher than the $2.10 average of the last five auctions of similar securities.

Investor reaction was curious considering the cold water that policy makers have been pouring on inflation fears lately. The reaction could indicate that inflation worries are bigger in the marketplace than are being acknowledged.

"What we've done here is built up another huge bubble, and the bubble specifically is the US debt market," says Michael Pento, chief economist at Global Delta Advisors. "When that pops—and it will, make no mistake—there will be nobody left to rescue us. We've set ourselves up for a much worse scenario."

Pento puts a different spin on the stimulus story, contending that injecting boatloads of stimulus that was generated through debt has only made matters worse. The stimulus shouldn't have been used, he says, and cutting it off now is too little, too late.

"We've gone miles across the rubicon," he says. "There's no V-shaped rosy scenario for what we are in. We're so far into debt and we've made so many promises we can't keep. We can either have a very serious depression or get on with the business of reinflating the bubble and trying to hyperinflate our way out of this. I can guarantee neither will have a happy ending."

To be sure, the scenario all depends on action at the central bank, which can be unpredictable when it is looking to change monetary course.

Fed Governor Kevin Warsh sent ripples of fear through the market last week when he wrote an opinion piece in the Wall Street Journal saying that "prudent risk management indicates that policy likely will need to begin normalization before it is obvious that it is necessary, possibly with greater force than is customary..."

The remarks were interpreted as meaning the Fed could begin to take steps soon to ratchet down easy-money policies, and investors reacted by sending stocks lower. Moreover, the incident may have provided a preview of market reaction to upcoming Fed moves.

"Reaction from the market had to do with the fact that investors don't believe that the economy is ready for the Fed to exit," says Quincy Krosby, general market strategist at Prudential Financial. "When investors believe it is time for the Fed to start tightening and changing the language in addition to the other programs, (the Fed) will exit."

But an early exit, as shown by the market's reaction to Warsh's comments, could rattle the markets and, as Roubini stated, take away the liquidity on which the market has built its stunning rally from the brink of another Great Depression.

At the same time, rumbles continue out of Washington that there could yet be another stimulus to come along, which could change everything.

"There's no way that Democrats want to go into election season in 2010 with a 10-plus percentage point unemployment rate, or with the housing market that's not seeing a sustained recovery," Krosby says. "You're going to see more stimulus come into the system."

But until policymakers' moves become clearer, investors are likely to continue to flock to the safety of Treasurys and corporate bonds, as well as the inflation-indexed notes that sold off so robustly on Monday.

Lynx's Tanous points out that his firm's Real Asset Fund, which seeks to provide protection against inflation, was up 5 percent in September.

"That wall ... to a degree has been somewhat of an artificial boost in that it's not necessarily part of a fundamental recovery in the companies themselves that have seen their stock prices go up," says Owen Malcolm, chief operating officer at Sanders Financial Management in Atlanta. "Fundamentally we just don't see where all the optimism is coming from."

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