Any traditional yardstick used to measure the duration of economic and equity market cycles is signaling that both the current recovery and bull market are approaching an inflection point.

Conventional wisdom holds the economy and financial market cycles are distinct and driven by different variables. That said, it’s not just coincidence that the current stock market rebound started in March 2009 and the recovery began in May of that year.

Furthermore, the deep recession and violent bear market that preceded the recovery both began in December 2007.

But that’s about all the current economic expansion and bull market have in common. From their low in March 2009 to their high earlier this year, the sustained surge in stock prices has been one of the most powerful in history.

In contrast, the economic recovery has been the weakest of most Americans’ lifetimes. Travel around the world and one will find the same melancholy sentiment that is pervasive in America.

This paradox explains why many have viewed the advance in equity prices as suspect, making this the least loved bull market in modern memory. Skeptics, and there are many, contend that rising stock prices around the world are primarily the result of synchronized global central bank manipulation, raising the question of whether asset prices are out of balance around the globe.

Dividend And Bond Yields
Finding evidence that Fed policy is creating distortions in financial asset prices isn’t difficult. Exhibit One is the gap between 10-year Treasurys and the dividend yield on blue-chip equities. As of early October, 10-year Treasurys were yielding about 2.0% while the Dow Jones Industrial Average was yielding about 2.5%.

That represents a dramatic departure from the post-1950s experience of American financial markets. From the 1930s until the late 1950s, risk-averse investors were so scarred by the Great Depression they expected and received a higher yield from equities than relatively safe corporate bonds.

When depression fears finally subsided, Mr. Market decided that the upside of rising dividends represented a better value than the safety of corporate bonds. Observers like the late Peter Bernstein noted that investors in the late 1950s wrongly assumed this change might be temporary. For the better part of the next 50 years, however, it proved permanent, as dividends generally yielded less than bonds.

Since 2009, however, the relationship between stock and bond prices and yields has changed. Late that year, Wells Fargo fund manager Margie Patel noted that the yield on shares of Clorox, as stable a consumer staple as one can find, exceeded the yield on its bonds.

One might attribute that to post-financial crisis jitters, but six years later the phenomenon remains widespread. Procter & Gamble shares are yielding 3.4% while its bonds give investors 2.7%. Microsoft stock pays a 3.1% dividend while its bonds offer a 2.5% yield. “When people look at marginal relationships, it says the marginal returns will come from yield, not growth,” Patel says.

Is the change in the relationship between blue-chip bond and equity yields a sign of a secular change in how markets price financial assets or is it the result of extreme, distorted monetary policy? One could argue that corporate America is responding to a new reality—scarce growth opportunities for capital projects and competition to satisfy the needs of an older, income-starved base of investors.

Patel, however, believes the Fed’s policy is a major culprit that is no longer helping the markets or the economy. The central bank, obsessed with finding excuses not to raise interest rates, doesn’t need to look far to find them.

Whatever the reason, the phenomenon is significant for investors, according to Loomis Sayles Vice Chairman Dan Fuss, who addressed this subject with Patel at Financial Advisor’s Asset Management Showcase on October 7. “More strikingly, those stocks now yield more than 30-year U.S. Treasury bonds,” he says. “Anytime those ‘dividend growers’ have a reasonable size sell-off, buying comes in.” Fuss is more sympathetic to Fed policy than Patel, but he agrees that minor changes in policy, like not reinvesting coupons from bonds on the Fed’s balance sheet, would be welcome.

Capital Allocation Decisions
Cheap money undoubtedly is driving capital allocation decisions as much as the relationship between stock and bond yields, however. A weak global economy and uncertainty about increased regulations are prompting corporations to favor financial engineering over investing in organic growth, according to Michael Cuggino, CIO of Permanent Portfolio Funds. “Many are borrowing [at very low rates] to increase dividends and buy back stock,” he notes. One reason behind the equity market’s weakness this year is that investors are no longer impressed by companies’ use of engineering techniques to boost earnings per share, which coincidentally happens to be a key metric of CEO compensation.

Some like Bob Eisenbeis, chief monetary economist at Cumberland Advisors and former executive vice president of the Atlanta Fed, also believe that the Fed’s zero interest rate policy (ZIRP) is seducing investors to reach for yield and take more risk than they understand. The upshot is they aren’t getting compensated adequately. Equities and real estate have boomed, in part, because they offer tremendous liquidity. Cuggino notes that vehicles like leveraged loans, distressed debt, asset-backed securities and certain structured derivative products have boomed even though they are less liquid and often quite complicated.

When it was established a century ago, the Federal Reserve was structured to regulate the nation’s banking system and to resolve or at least moderate the recurrent panics that plagued the nation for 50 years following the Civil War. Its mandate has always been broader in reality than what Congress spelled out when the central bank was conceived.

In the early 1970s, Fuss was running Yale University’s endowment fund and reporting to former Fed Chairman William McChesney Martin, then a board member of the Yale Corporation. During one of their conversations, Fuss suggested a logical course of Fed action to address the emerging problem of stagflation. Martin told the young endowment manager that his sound, sensible prescriptions would never materialize because the Fed was “completely a creature of Congress.”

In 1977, the Federal Reserve Act was amended to expand its mandate. As if it needed to be put in writing, the central bank was given the authority to “maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”

Fast-forward to the post-crisis world of global QE, when many question whether there is any political or economic goal that falls outside of the Fed’s purview. In the September issue of Financial Advisor, Salient Partners’ chief risk officer W. Ben Hunt predicted that the “TVA political experience of the 1930s is coming soon to the capital markets of today. Scratch that. It’s already here.”

Hunt posited the notion that if the capital markets morphed into an economic vehicle similar to a public utility, investors might be able to expect both a floor and ceiling on what they could expect in terms of asset price inflation and deflation. “You’re probably not going to lose money, but you’re not going to make a lot of money, either,” he wrote. “All of your capital market assumptions are now at risk, subject to the tsunami force of status quo politicians with their backs up against a debt wall.”

From a central banker’s viewpoint, the stable predictable world described by Hunt is an optimal environment. But how much control do they ultimately have?

When Monetary Policy Fails
Raising nominal GDP growth (inflation plus real growth) remains the primary goal of most central banks around the world. According to Eisenbeis, adding real growth plus inflation creates a decent proxy for what the fed funds rate should be, though it isn’t the formula the central bank uses. If it were, fed funds would be paying between 3.5% and 4.0%, a far cry from the current 0.1%.

Little wonder then that achieving their nominal GDP objectives remains remarkably elusive. For many overleveraged nations, a small amount of inflation could make their debt loads more manageable.

“It’s disturbing that we could have QE all around the world with negative interest rates and we can’t get inflation going,” says J. Michael Martin, chief investment officer of Financial Advantage Inc. in Columbia, Md. “Many people think real inflation isn’t even 1.5%.”

Indeed, the inability of central banks to spark any meaningful nominal GDP raises questions about the efficacy of the instruments in their arsenal. “The real economy is OK, but the nominal economy is where the problems are,” says Richard Bernstein, a former chief market strategist at Merrill Lynch who now runs his own asset management firm. “You can lead a horse to water, but you can’t make it drink.”

It’s no mystery what’s wrong in Bernstein’s view. “Monetary policy should be impotent when you are dealing with deleveraging from a debt bubble,” he says. “In the absence of the credit market functioning properly, you need fiscal policy to take charge. What you got was fiscal policy working in reverse.”

Since 2010, the U.S. private sector has been growing at about 3.0% a year, decent in a recovery from a financial crisis but hardly spectacular. “For the first time since the 1950s, government spending actually went down for several years [since 2010],” Bernstein says. Contrary to popular mythology, the 1950s were hardly the happy boom times some Americans vaguely recall. The economy experienced three recessions and grew at the same anemic 2% rate as it deleveraged from World War II.

America was only one of many developed nations to embrace austerity in the post-financial crisis world. In the European Union, budget guidelines theoretically placed a limit on any stimulus program a nation could initiate domestically. The European Central Bank (ECB) failed to launch a quantitative easing program until 2012, a year after Mario Draghi replaced Jean-Claude Trichet as head of the ECB.

Many share the view that comatose fiscal policy was a major cause of the weak global recovery. But skeptics pointed to the experience of Japan, where numerous stimulus programs and variants of zero interest rate policy have been implemented repeatedly for two decades with negligible results.

Even though the U.S. has a reserve currency and none of the restraints that EU nations face, the world is too interconnected to operate in a void. Even though the U.S. domestic economy has displayed sufficient strength for several years to withstand a small hike in interest rates, the problem, as minutes of Fed meetings reveal, is the rest of the world. “The Fed has a domestic mandate and international problems,” Fuss says.

Crisis Part Three: Emerging Markets
No less an authority than IMF managing director Christine Lagarde has led a chorus of voices urging the Fed to maintain the ZIRP in recent months. There is no question that many emerging market nations are facing severe headwinds, including China, Brazil and Russia.

In late September, Goldman Sachs told clients the global financial crisis that began in 2008 was entering its third phase—the first being the U.S. housing crisis and the second being the European sovereign debt crisis. Ground Zero for this third wave, Goldman says, is located in commodity-producing nations and emerging markets.

It is apparent, however, that the individual problems confronting these countries would be only tangentially exacerbated by a 25- or 50-basis point increase in the fed funds rate. China reacted to the Great Recession by launching a massive infrastructure program, building cities bigger than Houston on a quarterly basis that have very few occupants. But its transformation from an economy where investment has accounted for 50% of GDP to one led by services and consumption will take years.

Brazil was an immediate beneficiary of China’s stimulus but now finds itself grappling with spiraling inflation and corruption scandals. Russia, Nigeria and Venezuela are among the many petro-states experiencing severe recessions.

If any consensus surfaced at Financial Advisor’s showcase, it was a visceral aversion to emerging markets. Conditions in China, always hard to read, are likely to get worse before they get better.

“Yum Brands [a giant U.S. operator of restaurants in China] said things were fine in China in August,” notes Joshua Jones, portfolio manager of the Boston Partners Global Long-Short Equity Fund. By early October, Yum was blaming disappointing earnings on guess where.

The last time there was a financial crisis centered in the emerging markets was in the late 1990s, when these nations represented 15% of global GDP. Almost two decades later, their contribution has soared to 40% of the world’s output, as China’s GDP has quintupled since 1990.

With $28 trillion in debt stacked on a $10 trillion economy, China has its fair share of excesses. The good news, according to Jones, is that most of this debt is internally funded by its excessive savings rate, which reduces the risk to America.

Contrarian thinkers might conclude the best reason to consider reallocating money to commodity-dependent emerging nations is that investors today hold them in total disdain, according to Fuss. Still, he adds they have not been beaten up that badly in his view. That is quite a statement given that many Brazilian equities are down 80% in dollar terms from their highs five years ago.

In Bernstein’s view, many investors are confusing symptoms and problems. The symptom is the underperformance of such credit-related asset classes as gold, private equity, hedge funds, commodities and REITs, all of which outperformed other asset classes between 2000 and 2008. Since then, all these groups have been underperforming on a secular basis. The problem is the ongoing deflation of the credit bubble of the last decade.

Some of the current problems in the U.S. can be traced to the strong dollar and the collapse of oil prices, which have triggered a mild profits recession, particularly among multinationals and energy companies. The twin forces of a possible increase in the fed funds rate coupled with at least a temporary end of the S&P 500’s profit cycle played a key role behind the recent stock market correction.

Among portfolio managers at the showcase, the bias favoring the U.S. assets was pronounced. Jim Swanson, chief investment strategist at MFS, was outspoken in his view that the U.S. economic expansion was not “a juiced up cycle” and was “very unlike the past three cycles.” Superior profit margins and unit labor cost advantages make the U.S. very competitive in a Darwinian global economy.

Private sector growth of 3% a year and shrinking government spending are clear positives in Swanson’s opinion. Furthermore, perma-bears who cite the Shiller PE ratio as a warning sign of a bubble are relying on a measure that, while very useful in certain instances, possesses some serious problems, he believes. It fails, for instance, to reconcile changes in accounting regulations and currency regimes.

America’s attraction to global investors can be explained partly by its relatively quick recovery from the great recession and its newfound energy independence. Between 2000 and 2008, the dollar fell 50% and the greenback is now in the process of retracing that move. As companies and countries try to slash prices and devalue currencies, Bernstein sees the trend as beneficial for both the dollar and U.S. consumers.

America is still facing serious challenges arising from debt, disinflation and demographics, prompting the gloom and doom crowd to question whether the U.S. is becoming Japan.

“The question they should be asking is: Is the whole world becoming Japan?” Bernstein says. “This is why monetary policy is becoming increasingly impotent.”

Why? Aging populations will place more severe strains on Europe, Japan and China than they will on the U.S.

Meanwhile, the world economy remains afflicted by massive overcapacity in the wake of the global credit bubble. Bernstein says that this in many ways resembles the liquidity trap Keynes depicted during the Great Depression. There is “virtually no inflation in the developed world” and “we believe it will continue.”

Why? The global economy has been transformed into a Walmart world where everyone is cutting prices to gain market share. Compounding this Darwinian environment, nations like China are devaluing their currencies and exporting deflation as competitive weapons. The U.S. economy and consumer could “feast on the rest of the world’s problems,” Bernstein says.

But for how long? It’s true that America isn’t dependent on exports to the degree that China, Germany and Japan are. Imported oil is no longer the Achilles’ heel it used to be. That doesn’t mean the U.S. can remain immune from a world where asset prices drift out of balance as central banks flail  and fiscal policy is neutered by political dysfunction.

Sitting on top of an imbalanced world where other nations are grappling with a smorgasbord of woes is comfortable for a while, but it isn’t sustainable. The U.S. found itself in that position in 1945. For decades, wages climbed as productivity rose but by the 1970s, foreign competitors were figuring their own ways to feast off of America’s bloated cost structures.

American workers may be benefiting from advances in medical science and enjoying the fruits of clever technology but aren’t seeing meaningful wage gains these days. In today’s global supply chain, where economic agents can react in nanoseconds, competitive advantages don’t last very long at all. And one has to wonder whether investors here and elsewhere should expect much from their financial markets when they expect so little from their economies.