Are investors too bullish?

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, news) said it added $26 billion in new client assets, the most since 2008. TD Ameritrade (AMTD, news) 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.