Here's why I'm still defensive on stocks

Some of the same pundits who were worried about the lack of a 10-percent correction in three years are now waving the "all clear" sign as we have finally gotten the correction behind us.

Traders on the floor of the New York Stock Exchange.
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Traders on the floor of the New York Stock Exchange.

The process of correction, they say, has shaken out some of the speculative excess. For them, it now stands to reason that the path of least resistance for stocks is clearly up. Weaker hands have folded, and the massive amount of money that sits on the sidelines now has a chance to get in.

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As much as I'd like to give our unambiguous endorsement of this thesis, it's just not so simple. I remain defensive — and here's why.

I continue to believe it is very dangerous for the Federal Reserve to be opining on and manipulating stock prices. Last week was a perfect example. In the midst of the selloff, an influential Fed member (St. Louis Fed President James Bullard) went over the airwaves advocating for a continuation of the Fed's program of quantitative easing. The Fed's program of buying Treasury bonds and mortgage-backed securities (MBS) in an effort to suppress long-term interest rates had been expected to end this month with the next Fed meeting.

Now that Bullard has opened the door to an extension, many believe that the Fed's cover for extending the program would be the strength in the U.S. dollar. The dollar's dramatic appreciation (up nearly 9 percent against a basket of foreign currencies before a more recent pullback), they argue, would effectively result in the importation of deflationary pressures. Given the Fed's mandate of maintaining price stability, it would clearly be within the Fed's purview to fight these price pressures.

Whatever the Fed ends up doing later this month, Bullard's comments undoubtedly played a role in supporting the stock market as prices were in free fall last week. Strangely, though, it does not appear as though Bullard's opinion reflects the consensus within the Fed. It begs the question, is the Fed "put" still alive if just one Fed member remains dovish? Would two be enough? How about three? As long as the single biggest variable in investment decisions remains the course of Fed monetary policy, I will argue that there is a problem.

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During the course of this bull market, I have watched nervously as the market has shrugged off major risk factors time and time again when prudence seemed to us the best course of action. But investors have continued to operate (and prosper) by the dual mantras of "Bad News Is Good News" and "There Is No Alternative (to Stocks)". I would concede that there seems to be at least some fundamental foundation to the demand we are seeing for equities. Whereas in years past, investors seemed to be relying on a wing and a prayer (and the Bernanke/Yellen "put"), economic conditions, at least domestically, have improved.

Perhaps one of the most positive developments is the drop in oil prices, which will put hundreds of dollars each year in the back in the pockets of average Americans who most need it. In addition, interest rates have fallen sharply in the past few months. But the developments are not all positive. Growth outside the U.S. has slowed dramatically, and the large majority of Americans continue to struggle with weak employment opportunities and stagnating incomes.

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So the big question going forward, therefore, is: Do stock prices fairly reflect BOTH the positives and negatives? At some point, investors will no longer be able to rely on the Fed to save the day. When that happens, the focus will go back to fundamentals and valuations. With regard to valuations, our major concern is the sustainability of near record-high corporate margins. Earnings growth padded by unsustainable sources of growth — government deficit spending, lower consumer savings rates, tax breaks, excess labor capacity, restructurings, stock buybacks, debt refinancings, and deferral of investments — cannot last forever. In addition, when interest rates finally and definitively rise, there will be increased competition for investment dollars.

If there's one lesson that's been hammered home over the past 5+ years, it is to NOT fight the Fed. But I continue to feel that a dangerous moral hazard has been created. Will I look back on this era and question the assumption that stock prices can't go down as long as the Fed is around? I recall a similar assumption, not too long ago, regarding housing prices.

Commentary by Michael K. Farr, president of Farr, Miller & Washington and a CNBC contributor.

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