I thought it would be helpful to remind you once again of my longer term thinking about the stock market at this juncture. Surprisingly it is best illustrated by looking at the two charts above, neither of which is a stock market average.
In my view the single, most important thing to understand is that the Fed plans to continue its program of quantitative easing. And I think it won't end until the unemployment rate drops below 7% (currently 9%).
I think the Fed is doing the right thing here - correcting the mistake it made in the fall of 2008 and which it nearly repeated in the summer of 2010. What was their mistake? Failure to accommodate a big increase in the demand for liquidity which arose both times as a response to a banking crisis - in 2008 the crisis was in the US and in 2010 in Europe.
Until the unemployment rate drops substantially I don't think there is any risk of inflation exceeding 2 or 3% here in the US.
The thing to know about quantitative easing is that it raises the prices of capital goods by raising expectations about the nominal and real returns they will earn over the coming years. This change in expectations sends stock prices upwards. Asset price increases will lead to increases in employment and to a surge of business activity, both goals of the Fed.
How will we know that quantitative easing is achieving these goals? The first thing to be watching is the yield on the 10 year note (first chart above this post). On this weekly bar chart you can see that 10 year note yields surged upward when the Fed first undertook quantitative easing in March-April of 2009 and surged again when the Fed announced its second program of quantitative easing in November 2010.
These interest rate increases do NOT reflect significant changes in inflationary expectations ( the 5 and 10 year tips spreads have moved upward about 50 basis points since November). Instead they express the market's belief that economic activity is going to pick up and that the real return on assets is increasing. I think the 10 year note is headed at least to 4.50%. Ultimately it should trade above 5.00% yield in the process of reflecting expectations of 2-3% inflation and 3% economic growth.
So on this basis increasing bond market yields are very, very good for the stock market - exactly the opposite from what you are being told by the talking heads on TV and a lot of market bloggers I follow. When to start worrying? If and when this increase in yields stops or is reversed.
The top chart is a weekly chart of the US Dollar index. Quantitative easing in the US which is not matched by similar easing in the rest of the world sends the dollar down. From the point of view of encouraging economic growth in the US this is a very, very good thing. Cheap dollars increase demand for US assets and produced goods. In Europe the Irish and Greek economies are in depressions while the Icelandic economy, which also suffered a banking crisis, has gotten by with a relatively mild recession. Why? Ireland and Greece are Euro countries and could not devalue to restore competitiveness. Iceland is not a Euro country and its devaluation held to cushion the effects of its banking crisis.
Dollar depreciation is another sign that quantitative easing is working. I think the US dollar index is headed for the 60-65 range. Note the trend line and repetition targets.
Should the dollar start to rally strongly I think the US stock market will be in trouble because that will mean that the Fed's quantitative easing policy is no longer working.
