Fears of Market Bubble Prompt Investors to Seek Exit Strategy

Fears that the meteoric rise in stocks and commodities prices is creating another asset bubble have investors debating whether to pull back now or ride the rally until the bubble bursts next year when the Fed starts raising interest rates.

Warnings about another asset bubble—which have become more pronounced recently from economist Nouriel Roubini as well as others—stem from concern that the market's continued rally is not the result of an improving economy but the Fed's low interest rates, which make dollar-denominated assets cheaper.

Both stocks and commodities have surfed the wave for much of the year, sending stocks up by 60 percent from the March lows while some commodities, particularly metals and energy, have posted gains in excess of 100 percent.

"The thing that's super-difficult to gauge is how much longer will these assets all keep rising in tandem. It's virtually impossible to gauge but it could end up surprising people and go longer than people think," says Chip Hanlon, president of Delta Global Advisors in Huntington Beach, Calif.

"If that's the case, is it crazy to try and play this rally? No. But I just think it would be crazy to play it without having a very clear exit plan in mind. Hedge yourself, and be ready to act."

Indeed, while many analysts have focused on what the Fed's exit strategy will be from its various policies implemented during the financial crisis, there's been less talk about exit strategy for investors.

Pimco, which manages the world's largest bond fund, is advising investors to begin shedding riskier assets immediately.

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Paul McCulley, the firm's executive director, examined in a recent analysis the ramifications of a V-shaped, or sharper recovery, versus a U-shaped move, which would mean slower growth. He argues that the V-shaped recovery actually could pose a greater danger to investors as it might trigger the Fed to put the brakes on interest rates faster than the market anticipates.

"Simply put, big V'ers should be wary of what they wish for. U'ers meanwhile, must be mindful of just how bubbly risk asset valuations can get, as long as non-big-V data unfold, keeping the Fed friendly," McCulley wrote. "But that's no reason, in our view, to chase risk assets from currently lofty valuations.

"To the contrary, the time has come to begin paring exposure to risk assets, and if their prices continue to rise, paring at an accelerated pace."

To be sure, there are plenty of doubters that a Fed move would trigger a major reaction in the markets. They cite constructive trends in earnings and economic data that show a progressive but orderly growth in the economy that will support the current level of enthusiasm.

The fallout could come down to what makes the Fed raise interest rates.

"If it chooses to do that because the economy is on firmer footing, then it's reasonable to think the rally could continue," says Lawrence Creatura, equity market strategist and portfolio manager at Federated Clover Capital Advisors in Rochester, N.Y. "In contrast, if the Fed is in effect forced to increase rates for external reasons such as to defend the currency or to tame inflation driven by external forces,  that would be a negative and that would threaten stocks."

Even though Creatura is more sanguine about the market's future he too is wary of risk right now and is focusing more on tight sector and company-specific moves. He particularly likes natural gas but more because of its secular attractiveness rather than its dollar-based appeal.

"It's a stock-pickers game right now and that's where investors' energies are better spent," he says. "The more successful strategy in these times is to focus on company stories rather than the macro story."

The drumbeat against risk accelerates, though, among those who see the current rally as highly speculative and similar to the atmosphere before the market crashed off its October 2007 historical highs.

Just a Bear-Market Rally?

Steve Hochberg, chief market analyst at Elliot Wave International, in an interview with CNBC Thursday called this year's stock surge a bear-market rally that is running out steam.

Market bears are echoing that sentiment, saying that most leading economic indicators, such as capacity utilization and the velocity of money coming into the market—the so-called "M1" measure—do not point towards recovery.

"This buying does not signal a lasting economic recovery. It signals a surge of speculation of the same type that created the real estate bubble and the Internet bubble," says Walter Zimmerman, chief technical analyst at international broker United-ICAP. "It's cheap money driving short-term traders.

"It's not based on a recovery in employment, it's not based on factories starting back up again. It's based on a Fed-created interest rate anomaly that's been the spawning ground for every major speculative bubble in the last 20 years."

Using a strictly technical view Zimmerman says "there's no chance" the March lows will hold and sees the Standard & Poor's 500 tumbling to the 550-590 range next year.

"Our advice is maybe you can make another few dollars to the upside but the downside risk is so severe that our advice has been either you get out of the stock market here or you pick a level ahead of time that if it breaks below you get out," he says. "Forget about investing for the next couple of years. Focus on safety of your principal, keeping your powder dry."

Some have already taken that position.

"I've already chickened out and raised cash," says Delta's Hanlon, who started buying stocks when investor Doug Kass called a market bottom in early March but is now in metals, foreign-currencies and other cash-based investments. "If I miss any more, I'm in the spot where I'm going to have to say, 'Oh well.' Cash is not a bad thing today."

For those still in the market, expect to see more short-term moves and conservative stop-loss measures.

"We remain constructive on the nascent recovery but skeptical about broad market valuations in both equities and in the commodities central banks deploy exit strategies," John Stoltzfus, analyst for Ticonderoga Securities in New York, wrote in an analysis Thursday. "An increase in volatility should as usual bring both risks and opportunities for the quick and the steady. Traders, stock pickers and buyers on dips should benefit as things progress."

Buy-and-hold strategies also are likely to be tested going forward.

"It's not irrational to be a long-term investor now. It is irrational to take too much long-term risk," Creatura says. "This is no time to be a hero. Don't bet it all on red-7 at the roulette wheel."