So, here we are. More than two years into what started out as a credit crisis, one plus year after the Lehman collapse and a question that pertains to the one of the central workings of the equities market cannot be answered.

At last evening's Market Technicians Association Educational Foundation seminar, the question your trusty moderator (that's me) posed to the esteemed panel with its decades of experience was in regards to volume. Specifically, the equity markets' volume as recorded each day for every stock traded. That is, the volume that accompanies the price action that results in the market capitalization of the stock market that results in the market value of every investor's portfolio.

So, here we are. More than two years into what started out as a credit crisis, one plus year after the Lehman collapse and a question that pertains to the one of the central workings of the equities market cannot be answered.

At last evening's Market Technicians Association Educational Foundation seminar, the question your trusty moderator (that's me) posed to the esteemed panel with its decades of experience was in regards to volume. Specifically, the equity markets' volume as recorded each day for every stock traded. That is, the volume that accompanies the price action that results in the market capitalization of the stock market that results in the market value of every investor's portfolio.

On the assumption that my bifurcated earnings season produces underperforming mid- and small-cap sectors (resulting in the long overdue stock market correction), one very attractive investment strategy to employ while waiting would be a barbell approach with large and mega cap on one side and emerging markets on the other. The Smids (small and mid cap) would be held to a minimum.

This strategy covers both the short and near-term bases and should enable performance participation as the large- and mega-cap part of the equation benefit from the global growth story (which is where the growth actually is) and weak US dollar. The emerging portion also benefits from the global growth story while also providing the beta trade.

To help visualize key aspects of the commentaries posted on this blog recently, the accompanying 2 charts illustrate important patterns that investors should keep a close watch on.

An interview with David Malpass brings into sharp focus a key aspect of the U.S. economic recovery that far too few investors are tuned into. Specifically, the underappreciated dynamic that second, third, and lower tier companies (the backbone of employment growth in the U.S.) may not deliver the much anticipated above consensus earnings results this and future quarters ahead. Moreover, as the backbone of employment growth, weakness in second, third, and lower tier companies act as a depressant on wages, hours worked, and consumer sentiment. Therefore, how the U.S. (and global economy) will reach a sustainable recovery without the U.S. consumer is a riddle wrapped in an enigma.

Lacking a large exposure to global markets (where the growth is and where the weak U.S. dollar helps deliver strong short term results), the SMIDS (small and mid cap companies) on down are vulnerable to disappointing investors with at or below consensus earnings results next month. In this regard, David points out in the interview that above consensus earnings results this coming 3Q09 for large and mega cap multi-nationals may come to pass via pricing power pressures on all companies offset by volume growth courtesy of a cannibalization of the units growth to lower tier companies.

Now that the S&P 500 has hit my full year target of 1050 (made last December 30 as published in the Wall Street Journal’s “MarketBeat” blog) - with 3 months still left to go, I might note, cyclical bulls (like me) who have turned increasingly more cautious over the past two months (as stocks moved well past their fair value targets) continue to sell into the rally. The portfolio consequences of this sell-into-strength decision are two-fold – reduced profits and reduced exposure to a pullback.

As stocks moved higher into overvalued territory, the first course of action was to maintain a portfolio’s equity exposure (assuming it was less than 100%) to the total assets managed, which for accounts managed by my company was in the low 90% range. When stocks continued to march ahead these past few weeks, the course of action shifted to reducing the equity exposure, which now stands in the mid to upper 80% range.

Here are the stock market performance facts regarding September, courtesy Wall Street’s keeper of the historical keys, Sam Stovall:

“Investors may have a reason to fear a set-back in September. No matter if you look back to 1990, 1970, 1945 or 1929, the S&P 500 posted its worst monthly performance in September, losing 1.3% on average since 1929 versus an average monthly advance of 0.54%. What’s more, the “500” has declined an average 56% of the time, versus only 42% for all months, making September the worst month for frequencies of declines. However, during the 14 Septembers immediately following the end of bear markets since 1932, instead of posting the average 1.3% decline, the S&P 500 gained a median 2.0%. What’s more, the frequency of declines – at 36% following the end of bear markets – was substantially better than the average 56% for all years. Yet history should always be looked upon as a guide, not gospel.”*

The stock market rally since early March appears to have three distinct phases to it.

The first phase was the backing off from the economic abyss. The second phase was a bounce to fair value normalcy. The third phase (the one we are in now) is what I would call the return to business as usual phase (or “Recession. What recession?).

Back on August 3rd subscribers to my weekly newsletter - Sectors and Styles Strategy Report - read the following:

China may become the bigger fly in the bullish ointment. Unlike the US, China has spent all of its stimulus package money not on consumer demand related areas (where it is most needed) but on more infrastructure projects. Since the U.S. consumer is and will remain in balance sheet repair mode for a while, and developed economy consumers (Europe and Japan) reluctant and/or unable to pick up the slack, end user (consumer) demand must materialize from emerging economies. With savings rates very high in China and other developing economies, expectations of V-shaped global economy recovery of a sustainable nature (meaning balanced and asset bubble free) seem fairly unlikely.

Since peaking on July 10, the Macro Economic Reports Indicator (first introduced on this blog on June 17) has stagnated. Including the two major macro economic reports issued thus far this week (consumer confidence and durable goods orders), the indicator now sits a full 3 points below its July 10 peak (see table*). This is not a good omen for future earnings expectations.

15 times $70 = 1050
1050 minus 10% = 945

This is the fair value math for the S&P 500. An appropriate P/E times a believable operating earnings number (12 months forward – mid 2010) minus an appropriate discount rate (stocks are, after all, a discounting mechanism). Of course, one can debate the inputs and the appropriate discounting time period, but the methodology is flawless.

The above consensus earnings results produced thus far – 109 companies in the S&P 500 (29% of market cap) 10.3% above estimates* – are doing their thing and moving the fence sitters off the fence. No doubt some of the $3.5 trillion sitting in near zero interest rate money market funds is finding its way into equities. In the process, an overbought stock market gets even more overbought – moving right into the S&P 500 resistance zone of 950 – 1000.

As investors reacquaint themselves with their animal spirits, let’s do something constructive and take a moment to assess the investment significance of the aforementioned 10.3% above estimates fact.

For the past two months, I have made the argument that above consensus macro economic data would lead to above consensus earnings results and that investors would see the evidence of this as 2Q09 earnings season got underway. Based on the reports issued thus far, this argument has won the day as above consensus earnings results have matched the above consensus macro economic reports preceding them. Accordingly, stocks responded.

The second part of my argument was that such positive data would eventually encourage bottom up analysts (along with many investment strategists and top down economists) to reassess their more cautionary views and begin to raise their full year earnings expectations for this and next year. This, too, has begun to occur – none more significantly than from the investment strategy folks over at Goldman.

In case you hadn't noticed, there’s a big head and shoulders debate brewing. A bona fide bulls versus bear story.

excerpts from this week's "Sectors and Styles Strategy Report":

"A huge disconnect is underway. The financial markets are signaling not just economic stabilization but a robust (V shaped) recovery. This is most evident in the accompanying two charts – the yield curve and the TED spread.