Is Fed inflating stock bubble?

Adam Shell | USA TODAY

NEW YORK — Is the great stock market rally of 2013, which has been turbocharged by the Federal Reserve's easy-money policies, a boom to be savored — or a bubble to be feared?

The bubble debate has become increasingly murky in recent weeks as more of the traditional financial fingerprints Wall Street uses to identify a frothy market show up on investors' radar.

A growing chorus of Wall Street pros say a bubble is forming in the U.S. stock market. They blame the Fed's unprecedented stimulus, including its $85 billion in monthly bond purchases, for artificially inflating stock prices. There is concern that if the Fed does not dial back its asset purchases soon, stocks could shoot higher and become even more delinked from business fundamentals.

The Fed said this week that it would continue its asset purchases at the current level, once again delaying the inevitable tapering of a program designed to stimulate the economy by keeping interest rates low. The policy, however, has pushed rates so low that a lot of the $1 trillion the Fed is injecting into markets annually has made its way into the stock market.

"We believe a bubble is developing in stocks," says Patrick Adams, portfolio manager at PVG Asset Management. "Fed policy is forcing money into (stocks), pushing forward returns that would have come in future years. There are clear excesses. "

Signs of exuberance abound. The Dow Jones industrials and Standard & Poor's 500 are setting records at a pace not seen since 1999. And the year-to-date gains are huge. In a flashback to the 1990's dot-com stock craze, the Nasdaq composite is up almost 30%.

Similarly, the S&P 500's current price-to-earnings ratio, a gauge of how pricey stocks are, has ticked up as high as 16.7, says Bespoke Investment Group. That's the highest in a year and close to the 17-plus level seen near the market's last top in 2007, Thomson Reuters says. In another sign of optimism, Main Street investors who say they are "bearish," or think stocks will fall, recently fell to less than 18%, its lowest since January 2012, says the American Association of Individual Investors.

"There's no bubble yet," although the potential for one is there, counters Rod Smyth, chief investment strategist at Riverfront Investment Group. "It's hard to say stocks are in a bubble when you look at the pace of earnings." He says stocks are simply getting back to fair value after a steep drop and reflect an improving global economy. The S&P 500 is up just 12% from its 2007 high while corporate earnings have nearly doubled since 2009, Smyth says.

"The bubble could get bigger," warns Adams. "The Fed looks like it will continue to blow the bubble up a little bit more, which will just make the pain worse on the downside."