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'Frothy' markets remind me of 2007, and rising rates could kill the rally, Stephen Roach warns

Stephen Roach on the Fed and normalization

The stock market looks expensive and it may not be equipped to handle rising interest rates, according to Yale University fellow Stephen Roach.

The former chairman of Morgan Stanley Asia suggests Wall Street has a case of amnesia, and the prognosis is poor for the 8½-year-old rally.

"Inflation has all but vanished from the scene. Policymakers as well as investment managers, to say nothing of the investors that they represent, don't remember what inflation is like and what monetary tightening might be in that environment," Roach warned on Wednesday on CNBC's "Trading Nation."

Roach has been critical of the world's central banks — particularly the Federal Reserve.

"The point on policy is: Just because inflation is surprising in terms of coming in below what we think doesn't mean we should not restore our policy to a more normal approach," he said.

In a note earlier this week, Roach applauded the Fed on its "commitment to normalization of its policy rate and balance sheet." But he said it should have happened much earlier.

"The markets are frothy, and it's a froth again that strikes me as reminiscent of what we saw in a lengthy pre-crisis period in the 2003 to early 2007 period," he said. "I think the one lesson we learned from that crisis is that financial stability addressing frothy markets with a more normal, tougher, disciplined monetary policy is not such a bad thing."

According to Roach, the odds are higher than 50-50 that stocks will plunge as much as 10 percent in the final months of the year.

Roach said the catalyst could be anything from a North Korea strike to unexpected weakness in the U.S. economy.

"We are long overdue for a correction," Roach said.

The full interview with Stephen Roach