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It's a good question and everyone has an opinion. I've made the case previously that much of this rally in U.S. equities is purely a consequence of monetary policy and the Federal Reserve's QE III/IV policy of buying $85 billion per month of U.S. Treasuries and mortgage-backed securities. The Dow Jones Industrial Average (DIA) put in a close earlier in the week above its all-time high set back in 2007 at 14253.77. The S&P 500 (SPY) is really not that much farther behind the Dow and will probably set a record before this week is out - if not while I write this article. But, as I asked in the title, "What does it actually mean?"

The fundamentals for this equity market rally are very shaky at best. The question is can the money the Fed is pumping into the economy stimulate the demand side of the equation now that commodity inventories are high and prices are soft? That would be a recipe for a big bump in economic activity and it is just the kind of thinking that dominates Keynesian demand-side thinking. (click to enlarge)

What I find interesting is that the price-weighted Dow broke higher making headlines before the capitalization-weighted S&P 500 did. With the Dow it is an index whose price is easy to move with just a few actors. As of the afternoon of March 6th, 80% of the rise in the Dow has been concentrated in just 14 of the 30 stocks, with heavily-weighted IBM (IBM) leading the charge with more than 10% of the rise. Now that makes sense since IBM is 11.13% of the index's weighting and IBM has pretty much tracked the Dow all year. But, with the exception of Exxon-Mobil (XOM) and Caterpillar (CAT), most of the heaviest weighted stocks have outperformed the index.

I don't want to put too fine a point on it but it is clear that very small changes in the price of a few stocks can send the index up or down very strongly and mask either internal degradation or strengthening of the index as a broad measure of market health.

And this lack of breadth on the Dow is likely why the S&P 500 has not quite joined the party. It takes more conviction to move a capitalization-weighted index. In my mind the S&P carries a lot more weight even though the top 10 market cap companies can move the index pretty heavily. Frankly, if not for the spectacular thrashing that Apple (AAPL) has taken in the past few months we would all would have been reading and writing articles about these records weeks ago. Which makes the point that this rally in the S&P is broader than last year's when Apple and Google (GOOG) accounted for not only 40% of the index's total earnings per share but more of the price movement as well.

That said, however, we are still looking at a very expensive market by historical standards. The Shiller inflation-adjusted P/E of the S&P 500 is currently 23.74 versus a mean of 16.47 and a median of 15.87. I would also like to point out a couple of things that continue to support the liquidity-driven nature of the current market. During the Greenspan period of low interest rates and reckless money creation at least we saw the S&P rise with earnings to meet those price rises. Capital was at least put to work in a productive manner. It may have been ultimately unnecessary and misdirected capital but at least monetary policy had the intended effect to stimulate economic growth.

(click to enlarge)

Fast forward to the post Lehman Bros. bust and endless quantitative easing and we have the S&P rising in price along with earnings multiples. In other words the index is rising simply because of a rise in the supply of money.

So, at this point the question becomes, "What happens next?" and obviously there are at least two answers to it.

  1. The Fed makes good on its hawkish promises and squelches the money printing thereby snuffing out the rally just as the party is getting started.
  2. It continues on the current path hoping that the mix of lagging commodity prices due to over-capacity built up to support an unsustainable China, a failing Europe and low domestic energy prices create a favorable arbitrage that can spur capital formation and the rally continues with commodity prices and gold (GLD) playing catch up.

To be fair the widening gap between the Shiller P/E ratio and the S&P 500 would suggest something like that is occurring. I expect the Fed to continue to print and all talk of ending QE is simply that, talk.

So in the case of #2 happening buying laggard commodity index ETF like the PowerShares DB Commodity Index Tracking (DBC) would represent a great medium term trade. The equity markets will rally but commodities should outperform if the demand side has been properly roused from its coma.

Now, there is a third scenario which I'm more partial to, which posits that the dislocation between commodity and stock prices is a leading indicator of the markets flying headlong into the mountain hiding in the clouds. If there is no demand, money printing will not help things. If so, the Fed doubling down on QE to continue to manage the perception that rising equity markets mean a robust economy - and not the other way around - will ignite a firestorm of inflation as the demand for the dollar will not be able to keep up with the supply. This will send oil, gold and bond prices higher in nominal terms while the rally fizzles if not outright crashes until valuations are more in line with earnings at which point prices can be inflated by money printing again.

The net result of this scenario is a stagflationary period of high unemployment {check}, high food and energy prices {check} and flat to negative stock prices. Gold will be very volatile as capital tries to find the best place to go but will ultimately have to go higher to offset the expanding U.S. monetary base. Adjust your portfolio allocations based on which scenario you think is most likely.

Source: What Does The Record On The Dow Mean?

Additional disclosure: I own physical gold, silver and a bunch of goats