Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

One More Step Forward

Markets remain priced for economic weakness, with some possibility of a financial market meltdown, despite improving conditions.  Stock prices remain very low compared to bond prices, while government bond prices remain very high compared to corporate bond prices.  Both comparisons speak to a high degree of caution on the part of investors.  The economy is not playing along, however.  Barring an unexpected adverse shock out of Europe, which remains the market’s primary concern, the economy and the equity market would likely gather momentum over 2012.

Every measure suggests that investors remain fearful.  The earnings yield is extremely high compared to Treasury interest rates.  Stocks are cheap compared to bonds.  High yield bonds are cheap compared to high grade bonds.  Actual reported profits consistently beat earnings forecasts.  Price earnings multiples are low historically.  Consumer confidence remains low.  Such a high level of pessimism sets the stage for markets surprises, namely that bond prices may fall, while equities rally.  Investors are not positioned for such a possibility, pulling money out of stocks funds for three years running and depositing even larger sums in bond funds.  As the equity market rallies to reflect the strength in corporate profits, investors will be pressed to get back into equities to participate and to avoid losing money in bonds.  So, the stock market, which was nearly flat in 2011, has enormous upside potential.

The primary risk to this potential being realized is the possibility of financial problems worsening in Europe.  They are working on their issues, although painfully slowly.  But if they can recapitalize the banks and reduce sovereign deficits, this concern should fade.  Everyone will be watching, of course.

Domestically, monetary policymakers seem to be looking for an opportunity to inject more cash to buy mortgages to promote a stronger housing market.  As Fed Chairman Bernanke has stated, the housing market needs more help.  A new program to permit homeowners to refinance has been rumored and investors also think the Fed could announce a major mortgage buying program.  In fact, the housing market looks like it has already begun to recover.  Rents are rising, home construction starts have strengthened, and housing is already adding to GDP.  Still, a strong housing recovery would be very welcome.  It would also set the stage for a significantly stronger economy that produces more than 200,000 jobs consistently each month.  Even so, any new policy initiative out of the Fed is quickly becoming less likely, although a mortgage refinancing initiative remains possible.  Either way, the economic environment continues to improve.  Imagine when housing psychology catches up to reality.