Image: Stock market report © Corbis

Related topics: stocks, stock market, ETF, investing strategy, Anthony Mirhaydari

After years focused on conservative investments like gold and bonds since the economy imploded back in 2007, the average investor has been moving back into stocks in a big way.

Unfortunately, evidence suggests this newfound enthusiasm has gone too far, and at just the wrong time.

The good times already rolled

Last summer, as oil spewed into the Gulf of Mexico and everyone was gripped in fear over the prospect of a double-dip recession driven by the eurozone bond crisis, I laid out the case for an epic bull market: Ultralow interest rates would fuel a transfer of wealth from bondholders to stockholders as executives used cheap credit to fund stock buybacks, mergers and buyouts, and dividend increases.

I also thought that the economy was stronger than most people were giving it credit for, that the prospect of deflation was low, and that while the job recovery would be excruciatingly slow, corporate America was ready and able to reinvest in new machinery and employees.

So why do I sound bearish now? The rally has come a long way -- the Standard & Poor's 500 Index ($INX) has climbed more than 24% from its August low and is up nearly 94% from its bear-market low -- and looks ripe for a pullback. If you're diving into stocks now, your timing couldn't be worse.

Yet after two years of record inflows into bonds, retail investors are loading up on stocks for the first time in three years. People are excited about the markets again: Charles Schwab (SCHW) said it added $26 billion in new client assets, the most since 2008. TD Ameritrade (AMTD) reported that margin lending -- borrowing to buy more stock -- was up 31% last quarter from the same period a year ago. According to the American Association of Individual Investors Sentiment Survey, investors are at their most optimistic since 2003. And hedging activity is way down as investors shun protective put options -- protections against a downturn -- focusing instead on call options.

But as is typical, many investors are making this turn too late. I see a number of problems going forward for those who've just now rediscovered stocks.

The Fed's foibles

For one, the Federal Reserve short-circuited the recovery process by pumping an additional $600 billion in new cash into the financial system with its QE2 initiative just as things were recovering in the wake of the eurozone crisis last spring.

This came on top of its $1.7 trillion "QE1" stimulus operation that ran between 2008 and early 2010. And it comes on top of a near-zero interest rate policy that's going on its third year now. Not only was this latest effort unneeded, it's threatening to derail the economy by helping to reignite inflationary pressures and a 2008-style commodity bubble.

The Fed seems determined to pursue a strategy of asset price inflation -- the same strategy that was used in the late 1990s and the early 2000s to fuel rises in tech stocks and housing, enabled by ultracheap imports from China -- to keep inflation at bay. But this won't work again. The Chinese economy is being ravaged by rising prices as its laborers demand higher wages. The Guangdong province, the heart of China's export miracle, announced it will raise minimum wages by 19% in March, the second hike in 10 months.

As a result, early indicators of inflation, including import prices and input prices for businesses, are on the rise in the U.S. In December, import prices jumped at a 4.8% annual rate, compared with a 1.4% rise in consumer prices. China's seemingly insatiable demand for raw materials, its contracting work force (a result of its one-child policy), and the rise of food and fuel inflation will tie the hands of the Fed -- especially with the addition of two inflation hawks to the Fed's policy-setting committee this year.

The Fed's QE2 program will be phased out in June and is unlikely to be renewed. Central banks around the world have already started raising the price of money. Even the European Central Bank, which probably has the strongest case for easy money as it tries to keep Greece, Ireland and Portugal from being forced to default on their debts, is breaking out its inflation-fighting arsenal.

Inflation will put pressure on corporate profit margins and earnings growth. I'm already hearing lots of chatter from Wall Street strategists about the potential for a drop in the profit multiple -- that's a stock's price compared to its profit -- that investors are willing to pay going forward as the S&P 500's earnings growth rate drops from 99% year-over-year right now to 47% for 2011 to just 9% in 2012, according to Barclays Capital's Barry Knapp.

So what we have is a situation where all the good news I saw last year has been discounted by the market -- leaving a vacuum of higher interest rates, higher inflation, lower earnings growth and reduced policy options in its wake. Add to that the prospect of a tighter fiscal policy from the newly empowered Republicans in the House, and the likelihood that stocks will continue to move up without a meaningful and violent market correction is remote.

It's simply time for a pullback

To be sure, the market is due for a pullback. The S&P 500 hasn't closed below its 50-day moving average since Sept. 1. That represents the longest consecutive rally since early 2007. Since 1926, there have been only 16 rallies above the 50-day average that have lasted longer. And over the past 25 years, only four big rallies like this have been seen including the current one.

Moreover, there is evidence that liquidity is being pulled out of the market as professional traders take risk -- i.e., their money -- off the table. Emerging market stocks, especially Chinese equities, have underperformed badly over the last three months. Citigroup strategist Tobias Levkovich notes that over the last 15 years, the Shanghai stock exchange has tended to lead U.S. indexes by three months. Industrial commodities, including crude oil and copper, have been on the slide as U.S. stocks march to new highs. And precious metals, which blasted higher last year as the Fed restarted its printing presses, have been melting lower.

And just over the past week, the stock market has started to move at two different speeds as the smallest and riskiest stocks lag behind "safe" mega-cap stocks at a rate not seen since the April 2009 market top -- a sign of reduced risk appetite. I discussed this in a recent Top Stocks blog post.

A few more scary signs

There's more. Tom McClellan of the McClellan Market Report recently highlighted a number of troubling signs. The first is that the performance of closed-end bond funds has deteriorated since last fall. In a call from his office on the southern shores of Puget Sound, Tom told me that these funds provide a nice indication of what liquidity is doing. He likens them to canaries in a coal mine: They are the first to die, providing an early warning for stocks that something isn't right.

Image: Bond CEF A-D Line © MSN Money

When liquidity starts to dry up, as it is now, "less meritorious assets start to suffer." That helps explain the recent pullbacks in foreign stocks and commodities.

The chart above, provided by McClellan, shows the advance-decline line for closed-end bond funds. When the line is rising, it means that more bond funds are rising each day than falling. When it's falling, as it is now, it means that more funds are falling. The line had been moving powerfully higher since early 2009, but it is now rolling over -- something that hasn't been seen since early 2007 as the stock bull market was ending.

Translation: The canaries are keeling over.

Stock market weakness that wasn't accompanied by weakness among closed-end bond funds, examples of which are circled in the chart above, were short-lived affairs. The deeper selloffs were marked by declines in bond funds. The situation is more serious than many realize.

Anthony Mirhaydari

One more thing: Tom has found an eerie relationship between last year's commercial trader positions in eurodollar futures (which are a bet on the interest rates of dollar deposits at foreign banks) and stocks. While he's not sure why this indicator works, he has a hunch it has to do with liquidity. It did a nice job of calling the March 2009 market low, the April 2010 market high and the August 2010 market low.

Right now, eurodollar futures suggest we're due for a dramatic selloff in the days to come followed by a powerful rally into June -- and then a decline on a scale that hasn't been seen since the depths of the bear market.

So what to do now

To be clear, I still believe that over the next 10 to 20 years, stocks will provide better returns than bonds and that better days are ahead for the economy and the financial markets. The epic bull is still on.

But corrections happen as the great pendulum of investor emotion swings between fear and greed.

In short, the evidence overwhelmingly suggests that now is the time for caution, not careless greed. The unfortunate thing in all this is the timing: Just as average investors feel comfortable enough to start putting money to work in stocks again, the market gods conspire against them. As the ancient proverb says, "Whom the gods would destroy, they first make mad."

Over the past few weeks, I've recommended that my newsletter subscribers add a collection of short ETFs to their portfolios -- including ProShares UltraShort China (FXP), ProShares UltraShort Silver (ZSL) and PowerShares DB Crude Oil Double Short (DTO). For short-term traders, these all still look good.

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For traditional investors, the best advice at this point is to hold off on new purchases or increase your allocation to cash until the storm clears -- hopefully by the end of February. Over the next few months, as we move closer to the June expiration of the Fed's QE2 program and the drop suggested by the decline in commercial eurodollar positions, it could make sense to move to a more defensive stance ahead of what could be a nasty wipeout between June and October. I'll keep you posted.

Anthony Mirhaydari does not own or control a position in any of the companies or funds mentioned. He has recommended FXP, ZSL, and DTO to his newsletter subscribers.

Be sure to check out Anthony's new money management service, Mirhaydari Capital Management, and his investment newsletter, the Edge. A free, two-week trial subscription to the newsletter has been extended to MSN Money readers. Click here to sign up. Mirhaydari can be contacted at anthony@edgeletter.com and followed on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.