Montreal, Canada

Central banks led by the U.S. Federal Reserve are creating another dangerous precedent through the extension and acceleration of cheap money. It’s no wonder investors are scrambling to ditch the dollar and gobbling-up hard assets, common stocks and foreign currencies.

No other central bank is creating paper like the Fed. While some central banks are tightening monetary policy, the Bernanke Fed wants to extend a policy of cheap money.

Since late August when the Federal Reserve announced another round of money-printing (aka Quantitative Easing), world markets have rallied sharply. Everything, it seems, has been bid sharply higher.

Many assets now trade at two-year highs while some have hit new all-time highs recently. Commodities dominate the “new highs” paradigm, with gold, tin and cotton dominating the headlines this month.

The anticipation of yet another round of dollar devaluation has driven investors into risk assets – stocks, bonds, commodities and foreign currencies. Everything is now rallying in unison as correlation factors rise exponentially making the next correction a dangerous dislocation because of the tightness of most markets.

With the exception of Treasury bonds, diversification is unlikely to work ahead of the next global correction. Stocks, most bonds, currencies and commodities will plunge together.

Some warning signs, however, are worth heeding before adding to risk-based assets as we shortly enter a period of seasonal strength for the market in November.

Investors Intelligence surveys show advisors approaching the 50% bullish camp this week – historically a bad omen for rising equity values. That figure was more than 50% heading into the May “Flash Crash.”

And a bad dream called the “mortgage crisis” is still a headache for the markets.

Bank stocks and bank-issued debt are struggling to participate in the post-August rally. Credit spreads for bank bonds have widened sharply this month as investors tally the cost of the ongoing mortgage-foreclosure crisis in the United States. It’s hard to imagine a sustained rally for the broader markets without the participation of financials.

Commodities are also heavily overbought. On a near-term basis, just about everything in this space is now clearly overbought and vulnerable to a major correction when the U.S. dollar finally rebounds – if only temporarily.

When everyone is on the same side of the boat, you know it pays to be on the other side. Some sort of correction lies ahead before the end of the year for risk assets; I suspect, however, this will serve as yet another buying opportunity for investors because the Fed has completely lost control and will continue to dump dollars as global currency wars escalate. Commodities should benefit the most in this environment.