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Up to now, the rally of the last six months has been driven by a correction of the dislocations of last year, which impacted all asset classes. Those dislocations have now largely disappeared, and credit spreads, corporate bonds, interbank rates, and many commodities are back to where they were in September of 2008. Stocks, however, are not back to these levels, and are still far from it. Yet the price/earnings ratio of the S&P is back to its 10 year historical average, and by some measures (cyclically adjusted) it is above its long term average.

So what could drive stock prices higher? Either continued upward earnings revisions for U.S. companies, or liquidity. Americans are holding $3.5 trillion of cash in money markets, representing 73% of the entire market capitalization of the S&P 500 index. It seems that most people aren’t yet ready for stocks, if we consider that mutual fund flows have been heavily skewed in favor of bond and money funds. Yet if this money is mobilized into buying stocks, there is plenty of room for upside. Growing concerns about inflation due to central bank policies worldwide may also lead to fear that inflation could exceed the returns on money market accounts, which may cause investors to buy equities.

However, economic reality and the direction of the stock market have been diverging. In reality, unemployment is still rising and will soon hit 10%. Nominal wage growth is still falling. The “wealth effect” remains solidly negative, since every $4 lost from home values impacts consumer spending by $1, according to a recent study at the University of Chicago.

70% of total U.S. economic activity comes from consumer spending. The Consumer Confidence Index is published by a research organization called The Conference Board, based in New York. The Index is based on two measures: consumer assessment of the present and consumer expectations of the future. At no time in the past 20 years have the two been so divergent. The Index was down for the month of September to 53.1 (1985=100) from 54.5 in August, probably because the “cash for clunkers” program, which led to automobile consumption, ended on August 24th. More importantly, however, is the contrast between the present situation index (22.7) and the expectations index (73.3). Clearly expectations have run ahead of the present situation. The fourth quarter will be pivotal in determining which forces (fundamentals vs. liquidity) will dominate the direction of the stock market.

For the first three quarters of 2009, the Dow rose 10.7%, the S&P 500 gained 17.0%, and the Nasdaq rose 34.6%.

Grant Rogers Elizabeth Allen

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