Sluggish economy may signal correction

February 28, 2013: 1:49 PM ET
sp500 correction chart 3
Stocks are hovering around pre-financial crisis levels.
NEW YORK (CNNMoney)

The Dow and S&P 500 are flirting with all-time highs. The housing market is hot again. The financial crisis appears to be firmly in the rear view mirror.

But don't get too comfortable.

Weak GDP growth and the Federal Reserve's easy monetary policy may be setting the stock market up for a correction, according to Komal Sri-Kumar, the former chief global strategist at TCW who now runs his own consulting firm.

Sri-Kumar sees echoes of 2007 in today's markets.

Back then, there was a general perception that economic growth was strong, when in fact, it was quite sluggish. During the last quarter of 2007, GDP growth came in at 3%. By the third quarter of 2008, the economy had slammed into reverse.

But with stocks near record highs, investors had shrugged off the cracks in the economy ... until Lehman Brothers went bankrupt. For the next six months, stocks went into a deep dive, before finally bottoming out in March 2009. By then, the S&P 500 lost 43% of its value.

"The easy money policy during the final years of the Greenspan Fed worked to delay the appearance of a recession but could not forestall it!" Sri-Kumar wrote in a client note.

The economy officially entered recession in December 2007.

Related: Bonds are riskier than stocks

Investors are once again ignoring signs of weakness in the economy and are solely focused on the roaring bull pushing stocks higher. The latest reading on GDP showed that economic growth is basically flat.

Sri-Kumar says signs point to a stock correction coming during the first half of the year.

In fact, he goes even further, arguing that another recession may already be starting.

While the Fed has been propping up the stock market with seemingly infinite rounds of stimulus, or bond buying, Ben Bernanke can only do so much.

Interest rates won't stay low forever and the Fed has essentially backed itself into a corner, he says.

Related: Stocks 'need to be corrected'

"The Fed is creating a long-term risk. Interest rates may have to rise swiftly. As soon as they rise, the Fed could be setting the stage for a new recession," said Sri-Kumar. "A sharp increase in bond yields, whenever it occurs, will both increase the U.S. fiscal deficit and worsen the downturn."

When recessions start, stock corrections quickly follow.

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