Is the Market Too Frothy?

Most economists and investment professionals would probably agree that we're past the very worst of the financial crisis. Odds are good that we've made it through the darkest of the dark days. But where opinions diverge is on where the economy is headed next. Some pessimists are loading up on gold in expectation of further doom and gloom. Others are urging folks to get back to the business of investing in stocks for the long run. So who's right?

On the mend
Things have undoubtedly been looking up for investors this year. After getting beaten down to within an inch of its life, the stock market has roared back more than 60% from its lows. As you can see, quite a few well-known large-cap names have doubled or come close to doubling in price this year:

Source: Morningstar. As of Dec. 28.

But despite these impressive numbers, one high-profile investing expert is sounding the alarm on stock prices. Pimco's Mohamed El-Erian has recently warned that stocks are on a "sugar high" and that the current rally is unsustainable. He believes government stimulus that is propping up economic activity and a low interest-rate environment will soon wither away, leaving the economy high and dry.

El-Erian is predicting that stocks will drop roughly 10% in the space of a few weeks at some point, although he doesn't say exactly when this will happen. He is also predicting that our gross domestic product will grow at a roughly 2% rate over the next few years, quite a bit below the roughly 3% average growth we're used to. In response, El-Erian says he's selling his riskier holdings and loading up on U.S. Treasury bonds in expectation of renewed fear over the economy.

Acting in the face of fear
Sounds pretty dire, huh? But don't rush to cash in your stock holdings for Treasury bonds and gold bullion just yet. I do think El-Erian is absolutely right that the economy is in for a rough ride. Much of the economic growth that we've seen this year has been propelled by government stimulus measures. While the stimulus is likely to continue providing some juice well into early 2010, the second half of next year could be a little shaky. The economy could even contract again in the bottom half of the year. That's where the next danger lies -- in late 2010, after the effects of government actions are drawn away and the economy is truly left to its own devices.

I also agree that a market pullback is likely at some point. In this fragile recovery, it won't take much more than the whiff of further bank troubles or a dip in consumer spending or confidence to take the market back down a few pegs.

But while what the stock market does in the short run is anyone's guess, I still believe that there is a lot of long-term opportunity out there. Given that the past decade was the worst on record for stocks, odds are pretty good the next 10 years will be much better. That old idea of reversion to the mean tells us that there are likely to be some pretty hefty long-term returns for stocks in the next decade. Returns won't be as impressive as they would be in a normal, sharp, V-shaped recovery, but investors who stick with their long-term plan now should make out quite well by 2020.

And as a final note, if El-Erian truly does think that investors betting on stocks are likely to be disappointed, I can't help but notice a disconnect between that line of thinking and the recent announcement that Pimco is planning on expanding its offerings to include stock funds. It seems odd that the firm would choose now to get into the equity side of things if they don't expect the rewards from owning stocks to be that great. Bill Gross and the folks at Pimco are pretty bright, and I can't believe they'd make this move now without an expectation of financial payoff. Investors might be wise to focus on Pimco's actions rather than its words in this case.

Making the best of it
Ultimately, almost no one is predicting a sharp, robust return to growth in the near future. It's pretty clear that we're going to slog through a long, slow-growth period of time marked by chronically high unemployment. Until the millions of out-of-work Americans find jobs and consumers start spending again, we're going to be stuck in a grey area between recession and recovery.

The market may be a bit frothy now, but I'm betting it will still provide the greatest growth opportunities over the next decade. Investors can make the most of this period by keeping near-term expectations in check, keeping a long-term focus, and sticking to their investment plan, no matter what the headlines may read today or tomorrow.

Want another expert opinion on what 2010 will bring for stocks? Read why Matt Koppenheffer's magic green pig is looking for a big correction.