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The U.S. stock market has been remarkably resilient over the last couple of years. Amid a myriad of pressures, stocks have continued their post crisis advance to achieve new all-time highs in recent months. Unfortunately, such resilience comes at a cost, as the underlying fundamental reality is not at all supportive of the stock market gains in recent years. Instead, today's market is one that is remains driven almost exclusively by capriciousness of policy decisions by the U.S. Federal Reserve. An investment environment so reliant on the whims of human decisions by independently acting policy makers is perilous at best. And following nearly five years of deliberate asset inflation across capital markets, we are now at a juncture where the potential risks to the downside vastly outweigh the future rewards to the upside, particularly if this policy support stands to be slowly withdrawn in the months ahead. Thus, an allocation to cash with an emphasis on capital preservation remains a most prudent strategy in an environment increasingly fraught with the risk of potentially major loss.

The uptrend in stocks over the last year remains very much in tact. After enduring tests in the spring and fall of 2012, the U.S. stock market (NYSEARCA:SPY) entered into a sustained rally that continues through today. Since November 2012, the stock market has generally held above its 50-day moving average. And following the two recent breaks of this critical support level in June and August, the stock market quickly found support at its 100-day moving average and subsequently bounced higher. It should be noted that a few technical cracks are potentially developing behind this heavy stock armor, however. For example, momentum readings are increasingly fading with each new peak in the S&P 500 Index. But these concerns are few in what is otherwise a still solid technical picture.

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But a closer review the leading drivers of recent stock performance raises eyebrows. For example, two of the biggest percentage gaining days in stocks over the last several weeks came when Larry Summers withdrew his name from consideration for Chairman of the Federal Reserve and when current Chairman Bernanke announced that the Fed would not be scaling back on asset purchases associated with its QE3 stimulus program. These were not moves in response to an improvement in the U.S. economic outlook or the potential robustness of the upcoming quarterly earnings season from the likes of a Google (NASDAQ:GOOG), Apple (NASDAQ:AAPL) or General Electric (NYSE:GE). Instead, these were reactions to spontaneous human decisions tied to a policy making body in the Fed that now has an overwhelmingly large influence on capital markets on any given trading day. Such are conditions representative of a market that remains built on sand.

The Fed: A Chairman And His Printing Press

So what of the Fed and its recent actions over the last several months? They are dubious to say the least. In particular, I found myself dismayed by the Fed's decision to forgo scaling back its QE3 asset purchases, as it adds an entirely new element of risk and uncertainty to a market already badly deficient of anything resembling underlying consistency.

The Fed's decision to delay tapering can certainly be rationalized, but this is not the point. The Fed has spent years working diligently to establish clear and reliable communications for investors. Given that they have essentially overtaken all other drivers in completely drowning out the normal functioning of capital markets, providing consistency and predictability in their decisions is the least that they can do. This is what has made their policy actions in recent months so disconcerting. Starting in May, the Fed essentially blew up bonds, commodities and emerging markets in setting the table to begin scaling back QE3 asset purchases starting in September. But after having rattled capital markets for more than four months in setting firmly entrenched expectations that it would be scaling back asset purchases by at least $10 billion to $15 billion per month, the Fed shocked the markets by opting to do nothing when the day to take action finally arrived.

The Fed's decision to delay tapering was most troubling. This is not to say that they did not have good reason to do so. Perhaps they did. But by opting to do nothing in mid September, they have completely undermined the credibility of their communications strategy. In short, anything that they signal in regards to policy actions going forward cannot be trusted as reliable, for we now know it may be changed on a whim and without notice. This is now one more major element of uncertainty for investors to navigate. And at a minimum, a silencing of the now meaningless daily Fed cacophony in the wake of this recent policy surprise would be most appreciated at this point.

With all of this being said, it is worthwhile to consider exactly why the Fed opted to take no action. Several reasons are likely, but none are reassuring.

First, perhaps the Fed knows something we do not. Perhaps underlying conditions are worse than the consensus realizes or a potentially critical market disconnect is lurking under the surface. While this is possible, it seems unlikely, for the Fed's economic forecast has been if anything overly optimistic in recent months. And as for underlying disconnects, the Fed has been prone to misinterpreting such signals and lagging in their responsiveness at times when such situations present themselves. And nothing notable has surfaced in the weeks since the Fed's surprise announcement.

Another explanation is that the Fed is simply making it up as they go along. While this is a tempting conclusion particularly for those that are frustrated with the Fed, it is an unfair assessment. For whatever one might think about their policy execution, those serving on the FOMC are highly intelligent and calculating individuals. They almost certainly understood the gravity of their actions over the last several months as well as the significance of their inaction in September. Thus, the last minute decision not to act must have been driven by something they deemed important enough to change course.

The most likely explanation for the Fed's recent surprise announcement is the current fiscal policy mess playing out in Washington. It was almost certainly not lost on the Chairman and his committee that the President and Congress were headed toward a contentious budget and debt ceiling battle in October. Not wanting to repeat the sequence that took place during the summer of 2011 when the Fed ended QE2 in June 2011 only to see markets plunge in early August 2011 following a similar fiscal policy standoff, the Fed likely decided it was best to keep its foot on the monetary gas until this latest fiscal donnybrook played itself out.

But if the current fiscal policy battle is truly the reason for the delay in tapering, it is problematic for two important reasons. First, why did the Fed not anticipate this episode in advance and do a better job signaling this point to investment markets through its near daily parade of speeches in the weeks leading up to its mid September meeting. Second, exactly where in the Fed's mandate does it say that it needs to provide cover and serve as an enabler for fiscal policy makers. Instead of providing conditions for the President and Congress to continue dithering on policy and launching mind numbingly unproductive verbal barbs at each other, perhaps we would all be better served if the Fed stepped away and put fiscal policy makers feet directly into the fire. The assumption of personal responsibility in Washington would certainly be a refreshing change, and the Fed actually has the power to make it happen. The sooner they finally allow it, the better.

Stocks: Far Too Rich For My Blood

So as the Fed continues to do "whatever it takes", the stimulus continues to flow. But how much more does the stock market stand to benefit at this point? A variety of signals suggest that the best days for the stock market in the post crisis rally may now be behind it.

First, we have already seen this story before. It was just over one year ago on September 13, 2012 when the Fed stunned investment markets with the announcement of its QE3 stimulus program that was far more aggressive than expected. The market reacted euphorically that day in rising to fresh new post crisis highs. But that initial reaction effectively marked the highs for the year, as stocks faded lower by -8% for the next two months before bottoming in November 2012. While conditions are certainly different this, the set up is looking strikingly similar this time around, at least so far.

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But can stocks count on support from the upcoming quarterly earnings seasons? Earnings are not only likely to provide little support to stocks in the coming weeks, this fundamental support has been notably absent from the market over a year now. For example, since the first quarter of 2012, annual operating earnings per share on the S&P 500 Index have increased by a mere 1%. Stocks prices on the S&P 500, however, have risen over this same time period by 34%. In short, the significant advance in stocks since the beginning of last year has been driven almost exclusively by valuation expansion. Certainly not the makings of a sustainable market rise, much less the foundation for further gains.

But isn't earnings growth set to accelerate in the coming quarters? Aren't we on the cusp of a major advance in corporate profits? Sure, but only if you are willing to rely on forecasts that have been notoriously unreliable to this point. For example, the following is a chart from an article that I wrote on Seeking Alpha from June 2012. According to S&P at that time, corporate earnings were set to return to double-digit growth rates starting in December 2012. That would have been great if it actually happened.

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Corporate earnings growth ended up taking a decidedly different path over the past year. Instead of returning to double-digit growth rates by the end of 2012, earnings actually declined through the remainder of the year and recovered only modestly in early 2013. Yet here we are once again heading toward the end of the year with forecasts for earnings to return to double-digit growth rates by the fourth quarter and into 2014. To say that such forecasts are unreliable is an understatement, which is why I generally ignore forward earnings estimates and rely instead on data that is based on events that have actually happened.

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Even if earnings were to achieve the fantasy numbers forecast by S&P in the upcoming quarters, they would do little to fill the valuation gap that has now formed in stocks. Stocks are now trading at very expensive long-term valuations that bode ill for future returns expectations. At present, U.S. stocks as measured by the S&P 500 Index have a 10-year cyclically adjusted P/E (NYSEARCA:CAPE) ratio of 24.3. This represents a 48% premium above its long-term historical average over the last century of 16.4. In other words, if stocks regressed to the mean of its long-term average valuation, the S&P 500 would be trading at around 1170 instead of near 1700. Taking this one step further, if stocks were trading at levels that marked the final troughs at the end of past secular bear markets, the S&P 500 would be trading in a range between 500 and 850. This is potentially precipitous downside from current levels for stocks if they suddenly decided to return to normal past behavior. And looking ahead, stocks have historically averaged a negative return over the next ten years once CAPE valuations have reached levels comparable to the 24.3 in today's market.

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Stocks also face trouble indicated by the performance experienced by the variety of asset classes to which they have traditionally been highly correlated.

For example, commodities (NYSEARCA:DBC) have done nothing but drift sideways if not trend lower since the summer of 2011, yet stocks have exploded higher over the same time period.

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Common stocks and preferred stocks (NYSEARCA:PFF) traveled a similar path throughout much of the crisis and post crisis period. But since the beginning of April 2013, the divergence between these two categories has been widening at an increasing rate.

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And real estate stocks (NYSEARCA:VNQ) that until recently were flying high along with the broader market have experienced a jarring return back to earth in recent months. The fact that +20% year to date returns in real estate stocks was completely wiped out in just four weeks in May and June is a fact that should not be lost on stock investors. It should also be noted that the subsequent bounce back has been non-existent, as the asset class has continued to head lower in the months since.

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For all of these downside threats along with the persistent human error risks presented by the fiscal policy mess in Washington and the unpredictability of monetary policy from the Fed, it remains prudent to stand aside from the stock market and remain in cash for the time being.

What About Bonds?

But what about other asset classes that have traditionally been uncorrelated to negatively correlated with stocks? The investment grade bond market (NYSEARCA:BND) including U.S. Treasuries (NYSEARCA:TLT) is a leading example in this regard. And this segment of the market has shown some recent signs of promise after suffering a historically staggering rout since early May 2013. But it should be remembered that yields were poised to explode above 3% on the 10-year U.S. Treasury yield (NYSEARCA:IEF) in the moments leading up to the Fed's surprise policy announcement in mid September. The fact that this same yield measure has only come down 35 basis points to the 2.65% range in the weeks since suggests that renewed selling pressure may be lurking under the surface the moment the Fed renews rumblings about scaling back asset purchases, which could resume potentially as soon as the current fiscal policy fight in Washington is resolved. Thus, while bonds have offered some recent appeal, the short-term risks remained biased to the downside and cash remains the better alternative for now.

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The Precious Metals Market Remain Toxic

Of course, the natural inclination among investors in an environment marked by global policy unpredictability coupled with major central banks persistently engaged in aggressively easy monetary policy and money printing would be to allocate toward precious metals such as gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV). Unfortunately, the price performance in these markets remains downright toxic. Not only have the prices of these metals fallen precipitously throughout 2013, but the downside pressure also appears to be continuing as we move forward. For example, gold shed nearly -3% of its value on the first day of October when the mess in Washington fully came to a head, only to recover +2% the next day. Given the heavy carnage that has been inflicted on the precious metals market thus far in 2013, it remains prudent to stand aside until some of the recently unpredictable trading activity subsides and a clear and reliable trend begins to form. Once again, cash remains the better option for now.

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Cash Remains The Best Choice For Now

Many investors have spent their entire lives accumulating and saving the wealth that is now being deployed in capital markets including stocks. The objective on this savings is to try and generate a positive rate of return on their capital. But when asset prices become inflated and valuations stretched like they are today, the risks to the downside and the threat of a potentially sizeable correction more than outweigh the potential reward of what are likely to be incremental short-term gains at best across many asset classes. Thus, a shift in short-term focus from return on capital to return of capital is a prudent approach, for while the opportunity will always exist to reengage capital markets regardless of whether a correction materializes or not, it could take many years to recover from a massive losses associated with a major market correction, particularly now given that the monetary and fiscal resources that helped rescusitate the markets in the aftermath of the financial crisis are no longer available to uplift stocks if another sizeable correction were to suddenly unfold. During times of extreme valuation across asset classes such as today, sometimes the benefits associated with the certainty of a 0.1% return far outweighs the potential for a sharp decline of -20% or more. In such instances, cash represents an ideal portfolio allocation. And if such a correction does strike investment markets, having this cash at the ready is particularly ideal when scouring the aftermath for attractive return opportunities.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Source: Stocks And The Fed: Why I'm Staying In Cash