As Market Roars on Next Week, Listen to the Fed

Fed officials (probably including the Big Guy) are increasingly concerned about the surge in stocks, and they're talking about it.
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No, they are not happy about the stock market at the

Fed

.

They are not happy, and they are complaining.

Atlanta Fed

Gov. Jack Guynn complained on Monday of a "financial literacy crisis," and worried over "the institutionalization of unrealistic expectations." And there was Vice Chairman Alice Rivlin telling

CNBC

Thursday, "Surely the stock market is very high by any kind of measure. And I've been saying for some time, and so have a lot of people, that you have to be extremely optimistic about earnings to justify these stock values."

But this grousing has not counted for much with a market riding on what appears to be an unprecedented wave of liquidity -- even for the cash-rich month of January. Sure, valuations are high. Sure, earnings don't look so hot. Sure, interest rates are backing up. So what?

"None of this matters," said Larry Rice, chief investment strategist at

Josephthal

. "It doesn't matter to index funds. It doesn't matter to momentum traders. This is just mindless money getting poured into markets, with no sense of history."

The physics of the move are impressive. Contrary to what people thought was going on at the time, domestic mutual funds saw outflows in the fourth quarter, according to research done by

J.P. Morgan

. The money that drove the market off its Oct. 8 bottom came, instead, from managers putting the cash they raised during the summer selloff back into the market. Meanwhile, a lot of people, equity-shy after the drop, were putting their money into money-market funds. Now, along with the 401(k) and bonus and IRA money that normally comes into the market in January, there is the money coming out of money market funds and back into the market. Or so the theory goes.

The latest data from fund tracker

AMG Data Services

suggest something like this is indeed happening. For the first week of January, AMG recorded equity fund inflows of $2.745 billion. For the same week last year, when investors were still jittery over Asia, flows only came to $975 million. It's a situation that can breed a cycle of liquidity. As the market goes up, people get more excited about it (when the

Dow Jones Industrial Average

passes 10,000, as it may next week, people will get very excited), and that draws more money into the market. And stocks go higher. And so on.

"How are you going down?" asked Stanley Nabi, vice chairman at

Wood Struthers & Winthrop

. "There are not many IPOs, not many new issues, yet has been a flood of money coming into mutual funds. This in itself is an indication that the market is going to levitate until the music stops."

The trick of it is, though, is that the music does eventually stop. Cash does not gush into the market like this always and when it stops there can be trouble. This is what happened last year, when the market surged from mid-January to mid-April on a wave of money that dried up when tax season rolled around. For the highfliers that have been leading the market -- tech issues and the big-cap, index heavyweights -- this could be bad.

"I don't see a bear market coming," said Nabi. "I don't see a recession. The risk in the market is not that high, but the risk in owning some of the high-profile stocks has increased quite a bit."

And with the ever-expanding valuations of those stocks, the risk that the Fed will do something them has risen. On the

Federal Open Market Committee

, Rivlin and Guynn are moderates whose thinking is close to Chairman

Alan Greenspan's

. Their concerns over the stock market are likely his concerns as well. There is a growing sense that when the chairman speaks before the

House Ways and Means Committee

Jan. 20, he may try, again, to jawbone the market down.

"I would not be surprised if once again he voiced his opinion of where he thinks valuations are and what he thinks would be more realistic," said Kevin Flanagan, money-market economist at

Morgan Stanley Dean Witter

.

Meanwhile, the Treasury market will have to deal in the coming week with a growing sense that the Fed not only isn't going to ease anytime soon, it's not going to ease at all and my, in fact, tighten. After Friday's blowout jobs report, some are even beginning to talk about a future rate hike. "The economy is showing surprising resilience," said Flanagan. "It looks as if we reached a bottom and are maybe seeing signs of renewed momentum." If strong numbers keep coming in, Flanagan said, the Fed may move its bias back toward tightening.