Fast Advisor

Slow Growth Emboldens Fed to Stay the Course

Getty Images

Last week, the Federal Reserve reiterated its plans to continue buying bonds at the aggressive pace of $85 billion per month. This was widely expected. However, the Fed also hinted that it could decide to do even more shopping if employment growth and inflation do not meet its targets.

We suspect that Bernanke & Co. felt the need to include this new information largely due to the recent weak patch in the economy, which seems to be an annually recurring phenomenon. Of particular importance to the Fed was March's employment report, which came in well below expectations (but has since been revised upward). In addition to, or perhaps as a consequence of, the slow patch in the economy, inflation seems to have subsided in recent months.

(Read More: Profits Built on Soft Revenues Can't Stand Up Forever)

The slowing growth in price levels has further emboldened the Fed to stay the current course. The Wall Street Journal's Jon Hilsenrath reported: "U.S. inflation has moved noticeably below the Fed's 2% goal, part of a global slowdown. This has taken pressure off the Fed and other central banks to pull back from their efforts to boost growth by pumping new money into the world economy."

Below are three metrics widely used to track the level of prices in the domestic economy, the PCE, the CPI and the ECI. The versions of the Personal Consumption Expenditure deflator (PCE) and Consumer Price Index (CPI) used here exclude the prices of food and energy. The Fed tends to evaluate these indexes the same way because the price of food and energy can be volatile. The final price index is the Employment Cost Index (ECI).

The cost of labor is important because wage inflation often leads to more widespread inflationary pressures in the economy. In any event, the indisputable conclusion from this chart is that the economy is experiencing disinflation—a slowing of the rate of inflation—rather than troublesome increases in inflation.

Comfortable that he will be successful in reversing course when the time comes, Bernanke continues to press his bets. The Pavlovian response from stock investors has once again been to buy. The Fed's actions have birthed two new acronyms to describe the current investment landscape for stocks: TINA (There Is No Alternative) and FOBOR (Forced Buyers of Risk). Bad economic news is good news for stock investors because it means that the Fed will remain fully engaged. Good economic news is good for stocks as long as the metrics graphed above don't reverse course.

The rule is buy low and sell high. 15,000 is not low. Though it may, and likely will, continue higher, stocks are not cheap in my opinion. My colleagues Tobias Levkovich of Citigroup and Charles Kantor of The Kantor Group at Neuberger Berman disagree and feel that stocks are inexpensive. Kantor says they are as inexpensive as they've ever been.

The fundamentals tell a different story: The S&P 500 is up over 45 percent from lows about 18 months ago. Earnings have risen but most of the rise has been generated by PE multiple expansion (e.g. from 11x to 15x = ~35 percent).

The S&P500 is up 20 percent in the past six months. Again, earnings have risen, or at least are expected to rise, but the majority of the gain has come from PE multiple expansion (e.g. from 13x to 15x = ~15 percent).

Fast Adviser: Best Long-Term Investing Ideas
Fast Adviser: Best Long-Term Investing Ideas

Meanwhile, corporate earnings growth has begun to slow. S&P 500 EPS grew 6 percent year over year in 2012 and is expected to grow 4 percent in 2013. This, after a couple of years of above-trend growth as earnings rebounded after the recession. EPS rose 40 percent in 2010 and 15 percent in 2011. Companies are putting up decent bottom-line results for this quarter but many are missing on revenue.

In November 1997, the Dow crossed 6,000 for the first time and Alan Greenspanwarned of "irrational exuberance." Eight months later the Dow was at 8,000. Greenspan wasn't wrong, but trends can continue well beyond reasonable expectations. So while I may offer the most cogent rationale, it's important to remember that Keynes said: "Markets can remain irrational a lot longer than you can remain liquid."

While markets may be becoming expensive, they can certainly become a lot more expensive. Market tops are frothy and full of exuberance. It doesn't feel like we are there quite yet.

(Watch: Fast Adviser: Planning for the Long-Term)

If you're 10 years from retirement, your asset allocation should be more conservative. Despite what Warren Buffett said about owning all stocks, a 75-year-old widow or widower with $700,000 in investments, a small pension and Social Security can't ever go "all-in."And they can't reach for high yield when a loss of principal would be devastating and life-changing.

In rising markets, people tend to become complacent about risk. This is a huge mistake that can lead to costly consequences. Steady, dispassionate vigilance really pays off over time.

Michael Farr is a contributor for CNBC television and has appeared on numerous broadcasts and has been quoted in global publications. He is a member of the Economic Club of Washington, the National Association for Business Economics, The World Presidents' Organization, and The Washington Association of Money Managers. He is the author of "A Million Is Not Enough," and "The Arrogance Cycle." His new book, Restoring Our American Dream: The Best Investment, debuted in book stores on March 30.