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"When falsehood can look so like the truth, who can assure themselves of certain happiness?"

-Mary Shelley, Frankenstein

I fear that the Federal Reserve has created a monster. This monster is a distorted mass of liquidity that is propelling stocks and other asset prices to soaring heights. But while the monster may appear a calm and coherent supporter of financial markets today, it may only be a matter of time before it transforms itself into an angry and malicious beast that will ultimately leave chaos and destruction in its wake.

For those that have read my articles on Seeking Alpha, I have long been a critic of Fed policies in the wake of the financial crisis. But with this being said, my criticism does not extend to Fed Chairman Ben Bernanke as a person. To the contrary, I have a great deal of respect for him and the tremendous challenge he faces as effectively the leader of the monetary policy during a time of financial crisis. And I believe the policy actions he has pursued in the wake of the crisis are driven by the best of intentions and the strongest conviction that these are the necessary steps to resolve the situation. But such dogged faith in pursuing the same policy response may be leading markets to an even greater dilemma down the road. And reflecting back on a classic work of historical fiction suggests why this could ultimately be the case.

In the novel Frankenstein by Mary Shelley, Dr. Victor Frankenstein was from a very young age focused on applying science to produce extraordinary results. After achieving great academic success, Dr. Frankenstein develops a process to bring a man made being to life. And so it is that Dr. Frankenstein's monster comes into existence in a form that is larger and more powerful than his creator. Initially, the monster is intelligent, well spoken and kind. But over time and as a result of prolonged mistreatment and neglect, the monster transforms into a resentful and vengeful creature that acts out violently and destructively. As its creator, Dr. Frankenstein sets out to destroy the monster. But in the end, it is Dr. Frankenstein that is defeated in his pursuit.

Fed Chairman Ben Bernanke is also an individual that enjoyed tremendous academic accomplishment in areas associated with financial policy. Along the way, Dr. Bernanke gains notoriety for his theoretical policy approaches to battle against deflation and financial crisis, the last of which we had previously witnessed during the Great Depression. And as Fed Chairman during the current financial crisis, he has unleashed an unprecedented amount of monetary stimulus into the global system. Today, many worry that the magnitude of liquidity unleashed may stretch well beyond the scope of the Federal Reserve's control. Although this mass of excess liquidity has been generally well behaved and supportive to financial markets, the potential exists that it could eventually transform itself into a catastrophic and destructive force leading to hyperinflation or something else even worse. And by the time Dr. Bernanke and the Fed try to act to rein in this mass of liquidity, it may be far too late.

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The impact of the Fed's aggressive liquidity injections on the stock market has been well documented. Since the market bottom in March 2009, the stock market has soared as long as the Fed was pumping stimulus in the form of quantitative easing, or "QE", into the system. Although the latest round of stimulus is known as Operation Twist, it is effectively QE3. This is due to the fact that the Fed is receiving longer dated Treasuries from the banks in exchange for what is effectively cash equivalents in U.S. Treasuries set to mature in the next three years, for this is about as long the Fed has committed to keep short-term interest rates pinned at 0%. While the stock market euphoria in response to this stimulus has been a nice near-term market high, it has created a whole new host of potential problems for down the road.

"With how many things are we on the brink of becoming acquainted, if cowardice or carelessness did not restrain our inquiries."

-Mary Shelley, Frankenstein

Before going any further, it should be noted that I fully supported the Fed's implementation of QE1, as it was a necessary step to prevent the collapse of the global financial system. But I strongly opposed both QE2 and its most recent policy acrobatics of stealth QE3 in the form Operation Twist and setting specific target dates for its zero interest rate policy. My reason for opposition has been many.

The first and perhaps most importantly reason is based on principle. The primary justification and defense for QE1 at the time was that we needed to save the financial system from collapse. This would give policy makers time to take the necessary steps and carry out the required changes to help resolve the problem and ensure it would not happen again. Recalling Dr. Bernanke's 60 Minutes interview from March 2009, we called the fire department for the man who was smoking in bed so that we would not burn down the town. But here is the problem over three years on, hardly any of the necessary steps have been taken and few of the changes have been made to address the problems that caused the crisis. Instead, many of the bad behaviors in the financial system been allowed to continue unchecked. It has been the equivalent of going out and buying cigarettes and sleeping pills for the neighbor that was frantically rescued from the fire years ago. This is simply unacceptable after all this time and following so much damage caused to the system.

And instead of forcing these financial institutions and the markets to stand on their own after the end of QE1, the Fed immediately stepped back in with more support in the form of QE2, and later still with stealth QE3 Operation Twist. But here's the thing - we were no longer on the brink of crisis when QE2 and stealth QE3 Operation Twist were implemented. Also unacceptable, as such actions not only postpone the necessary corrective actions, but they also cause the distorted monetary monster to increasingly grow in size.

The mass of distorted liquidity has direct implications for the stock market. This is due to the fact that the stock market is clearly not comfortable trading anywhere close to current levels. This is evidenced by the fact that the moment policy support is ever withdrawn, the stock market collapses. And in many respects, this makes Dr. Bernanke's liquidity fueled stock market potentially far more destructive than Dr. Frankenstein's monster. Just like the monster from Shelley's novel, a stock market that is in a perpetual decline is horrid. Thus, it repels investors away from it so they can try to avoid being hurt. However, a stock market that is in a perpetual climb is attractive. Thus, it draws investors toward it, potentially placing them directly in harms way.

Now some might contend that the strength in the stock market over the last few years has been driven by the improvement in the economy instead of monetary stimulus. But here is the problem with this argument. If we are truly in the midst of a sustained economic recovery, why has the Fed been so quick to intervene with continually aggressive policy support? If conditions were actually improving, would we not instead expect the Fed to be contemplating exit strategies for monetary policy instead of debating addition support strategies? Looking at this from a different perspective, if the currently still sluggish rate of economic growth is all that we have to show for three years of massive monetary stimulus complemented by some hefty fiscal stimulus along the way, this should actually be more cause for genuine concern than optimism.

The same could be said for corporate earnings as it relates to the stock market. Certainly, earnings have improved in recent years, but what has been the primary source of this improvement. With corporate profit margins running at historical highs over +2 standard deviations above the mean, this suggests that aggressive cost cutting has driven much of the recent earnings growth. With companies left with nothing else to cut but bone, economic growth must be sufficiently robust to drive further profit growth from here. In an environment where input costs such as oil are now skyrocketing and economic growth prospects remains lackluster particularly with Europe heading into recession, this will be a tall order indeed. Compressing profit margins are typically negative for stocks, and we may already be seeing these forces at work following what was a generally weak earnings season for Q4.

More of the same could be said for valuations. I hear almost daily in the media about how stocks are trading at historically cheap multiples and thus represent an attractive opportunity. But what always gets left out of this discussion is an evaluation of exactly why stocks are currently trading at such discounted prices. During periods of economic uncertainty and pricing instability, investors are less willing to pay for each dollar of earnings. This is due to the fact that they have less certainty about both the ability of the company to generate this dollar of earnings as well as the future value of those earnings after inflation. Typically in the wake of a recession or worse yet a crisis, stocks typically trade at steep discounts to their historical average for some time for these very reasons. However, by some measures, stocks are currently still trading at a vast historical PREMIUM to historical valuations today. In this context, stocks may not be cheap after all. I potentially quite expensive instead.

"How dangerous is the acquirement of knowledge and how much happier that man is who believes his native town to be the world, than he who aspires to be greater than his nature will allow."

-Mary Shelley, Frankenstein

But it is in the future where the monster potentially meets the market head on. By pumping the markets full of liquidity, they have been elevated to a level that is well above fair value and has proven unsustainable the moment policy support is removed. By these actions, the Fed may have stretched way too far and essentially placed itself in a trap at the mercy of the monstrously distorted mass of liquidity. Here's how.

The economy needs to improve meaningfully from here to fill the valuation gap that has been created by aggressive monetary stimulus. And this growth needs to occur with low inflation, which on certain measures such as energy prices is already spiking higher. But if the economy starts to improve dramatically, the Fed will be under heavy pressure to begin withdrawing stimulus. This would almost certainly serve to quickly sap the wind out of the sails of the economy and put us back where we started.

The economy continues to be weighed down, however, by the forces of the crisis that still have not been cleansed from the system all of these years later. For example, we still have a banking system that is operating under mark-to-fantasy and remains reluctant to lend to all but the highest quality borrowers. So the first scenario of rapid growth is not likely to be a problem in the near-term. But the problem is that a slower growing economy is even worse for the market outlook. For if the economy is growing just enough that it forces the Fed to stay on the sidelines but not enough that it can fill the air pocket created to this point by the liquidity monster, then markets will be left without support and will be induced to seek out their true fair value, which by some measures is below 1000 on the S&P 500 Index.

Ironically, the best scenario for the stock market in the short-term is if the economy continues to languish. This is because the Fed will then have the flexibility to apply even more policy stimulus such as yet another round of quantitative easing. But what may seem best for the markets in the short-term only adds to the mass of the distorted liquidity beast in the end. At some point all of the liquidity that has been pumped into the system will need to be withdrawn. And the larger the liquidity beast is allowed to grow, the more painful this ultimate unwind process will be.

In many ways, we may very well have been much better off if the economy was left to face the monster and cleanse itself in the second half of 2010 after QE1 came to an end and the financial system had been generally stabilized. It certainly would have been a painful process at the time, but it was a necessary step and much of the work would have been behind us by now. But instead we watched the monster get fed a heaping dose of QE2, so we can only look back now in early 2012 and wonder what would have been.

So the question then becomes how best for investors to fight this increasingly distorted liquidity monster today. The key remains to stay hedged and to stand at the ready to capitalize on opportunities when they present themselves. As long as the liquidity monster remains calm, this includes an allocation to stocks. But focusing this allocation on the more defensive names that have recently been out of favor is a prudent approach from a risk control perspective. Representative names in this regard include McDonald's (NYSE:MCD), HJ Heinz (NYSE:HNZ) and JM Smuckers (NYSE:SJM).

Recognizing that one of the main threats of the liquidity monster is price instability suggests an allocation to those categories that can benefit most from an inflationary outbreak but are also suited for deflationary environments is also worthwhile. These include U.S. Treasury Inflation Protected Securities, or TIPS (NYSEARCA:TIP) as well as precious metals such as gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV).

Lastly, it remains important to constantly reevaluate your asset allocation mix. What is insidious about today's liquidity monster is that it undermines the correlation relationships across asset classes. Securities that were previously uncorrelated as recently as a few months ago may now be highly correlated, while others that were recently highly correlated may now be not. Thus, a constant recalibration of models is required in an attempt to adapt along with the monster and try to optimize the opportunity set.

In the end, Dr. Frankenstein succumbed at the expense of his monster and it all ended badly. Let's just hope the same is not true of Dr. Bernanke and the Fed's liquidity monster today. It should be interesting to see.

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: Fed Policies: Dr. Bernanke's Monster