THE BLOG
10/13/2010 04:12 pm ET Updated May 25, 2011

Beware: This "Fed Rally" Looks Like a Trap

Happy days are here again!

Economists have declared that the recession's been over for more than a year. Last month, U.S. stocks experienced their best September performance since 1939. The Nasdaq index was up 12% for the month, while the Dow Jones Industrial Average gained nearly 8% and the S&P 500 was up about 9%. And since the calendar turned to October the indices have only continued to climb. After today's 75-point gain the Dow is comfortably back above 11,000 for the first time since May.

Wall Street clearly is popping the champagne corks as compensation at investment banks is on pace to reach yet another record level. So now it's time for everyone to climb aboard before the train leaves the station, right? As any aggressive investor knows, missing out on a rally is the same as losing money. You have to get in on this.

Well, not so fast.

Because if you peel back the veneer and look at what's supporting these gains the picture is far less sanguine than the rising indices and Wall Street euphoria would indicate. In fact, this rally could turn out to be another trap for average investors.

The financial media is calling this move a "Fed Rally." That's accurate because investors essentially are betting that the Federal Reserve is going to ride to the rescue of America's stagnating economy. This speculation was confirmed yesterday when the Fed released minutes from its latest Federal Open Market Committee meeting showing that most Fed officials favor a fiscal stimulus plan.

The Fed deserves credit for trying to jumpstart the economy. Clearly the recession doesn't feel over to typical American families that are stretched to the limit or to the millions of American workers who remain unemployed or underemployed.

The problem is an intervention by the Fed isn't likely to trigger the long-term economic solution we need. The Fed's primary tool is providing liquidity. It uses its ability to buy and sell securities to increase the money supply and ensure that companies (and by extension individuals) have access to the capital they need. But with interest rates already at historic lows our problem isn't liquidity.

As the New York Times recently reported, corporations are having no problem raising capital right now. The issue is they're holding onto their cash rather than spending it and creating jobs. It's easy to see how this situation could create a downward spiral where fewer people have jobs and therefore don't have money to spend on the products that American companies produce. And since interest rates already are ridiculously low, with the 10-year Treasury bond yielding around 2.5%, more liquidity is unlikely to break this cycle. The issue is much more complicated. Corporate America needs to change its psychology, not improve its access to capital.

Stock markets are forward indicators, meaning investors and traders typically respond to what they think is going to happen rather than what is happening. In this case, Wall Street is expecting the Fed's intervention to work. That's what's driving the indices higher and causing so much glee among investment professionals.

The Chicago Board Options Exchange has an index that essentially tracks investor fear in U.S. financial markets. Called the VIX, the index measures volatility spikes, with a higher number indicating that there's more fear in the market. For example, after Lehman Brothers collapsed in 2008 the VIX rocketed above 80. Today it's below 20, meaning investors are surprisingly complacent considering the skittish nature of the economic recovery.

This may seem like a good sign, but it probably isn't. Indeed, many professionals consider this a signal that the markets have become overconfident about America's immediate economic prospects. If nothing else, it appears that the Fed's intervention already has been priced into the stock market. As a market strategist told the Wall Street Journal, "If it gets under 20, in this environment that's dangerous."

So for average investors my advice is to be careful buying into a rally based on the Fed rescuing the economy. Because for all of the Fed's power, it can't change the way corporate America feels. And that's what needs to happen before a lasting recovery can take hold.