Stock Mkt Capitalization Preference

The p/e ratio on estimated 2010 eps for the Value Line equal
weighted arithmetic index (1700+ stocks) is now over 20x as it
is for the Russell 2000 smaller cap index. This compares to a
15.1 p/e for the SP 500 on a comparable estimate. The p/e
premium for the mid / small cap indices has been expanding
as this cyclical bull market rolls along. Moreover, the smaller
the cap, the faster has been the acceleration of relative p/e.

My view on this issue is that too many stocks are now trading
at riskier high p/e's and that if you like the smaller caps as I do,
you have to become far more selective going forward. The big
problem with smaller cap, faster growing companies is that folks
rarely are realistic in looking at how quickly and rapidly growth
potential can decay over time. they tend to extrapolate high
growth rates out too far in time to justify the p/e ratio so that
the earn-out period remains competitive with other stocks. Thus,
when the smaller guys go to a premium, it is likely that the
universe of overpriced srocks is expanding. So, you have to
research the potential of smaller cap stocks more carefully now
and not rely on the positive price momentum of the market
to bail you out.

The best method I know to tell when capitalization size preference
may be changing is to look at the relative strength of the mid /
smaller universe compared to the cap weighted SP 500. Have
a look at the Value line Arithmetic ($VLE) compared to the
SP 500 which I link to below. Notice the importance of RSI in
the short run and the power of trend favoring the $VLE since
late 2008. It will take a substantial break of trend to confirm a
change of leadership. Chart.

A Note On Goldman Sachs

I first did business with Goldman in 1974. I had a nifty battle or two
with their research partners over the outlook for the bond market
back in 1982, and was then codified as "acerbic" at their shop. They
have been as arrogant as other Street guys for all those years, but
have also exhibited a certain sanctimony that annoys folks. They
are masters of coating the firm with teflon no matter how nit-picky
an issue might be. And like the Gov. they used to like to ask "How
can we help?"

Our policy as fund managers was never to tell them anything they
could use for a trade or a marketable idea unless you wanted them
to do something that benefited your performance. SOP.

Goldman is not an especially creative firm. Their strengths are early
trend spotting in banking and trading and the willingness to commit
sizable resources to back a product or service on the way up and, to
find ways to exploit same on the way down.

The SEC suit involves allegation of fraud in the marketing of a highly
specialized private placement by Goldman and will be decided on
the cumulative weight of the evidence the SEC presents. If the
SEC makes its case, and this is not the tip of a large iceberg, few
large Goldman clients will depart. After all, there is no shortage of
guys out there who have clipped GS once or twice over the years,
either.

Short Rates, $USD, Fed Policy

My nearly 100 year long T-bill / inflation regression model suggests
the 3 mo. bill should be 2.1% presently. By the end of this year, the
model will likely provide a reading of 3.5%. The Fed is keeping it low
indeed.

Measured yr/yr, inflation has been running over 2% this year. So,
with deposit rates negligible, the US dollar is again losing purchasing
power and savers are taking the hit. You have to go out 5 years on
the Treasury curve to cover the inflation nut currently. With
sovereign risk credit issues in Europe, the trade weighted dollar has
been firming on a modest flight to quality, but the underlying
fundamentals for the $ have turned weak.

The Fed is resolved to maintain its 0.0 - 0.25% policy on the FFR%.
My indicators are now at 50% in favor of a rate hike. As the economic
recovery proceeds and capacity utilization and private short term
credit demand firm up, the case will be much stronger to raise
rates. The US operating rate is now around 73.5%. Normally, the
Fed has waited until that CU% rises above 80% to increase short
rates, although it started raising the short rate in 2004, when the
operating rate hit 77%. Waiting to raise rates until capacity
utilization moves toward 80% is a longstanding Fed practice because
it is at that level when inflation, excluding energy and fuels, begins to
accelerate, and is also when capital spending can begin to outstrip
business sector internal cash flow to put added pressure on credit
demand. So, the Fed figures it still has time before it should push up
rates and is not abandoning a long held practice.

Despite the ZIRP Fed policy, the odds of serious bubbles arising are
low since the broad measures of credit-driven liquidity are barely
growing. Individuals and institutions have been drawing down
money market holdings to fund the capital markets, but that is an
exercise with considerable finitude.

the yield on the 1 yr Treasury has been creeping up, but it might have
to take out .75% to suggest players are sick and tired of the Fed's
ZIRP policy. 1 yr. chart.

Stock Market -- Shorter Term Technical

The rally that started in early Feb. has been shaky for several weeks
as today marked the third break of a short term uptrend line. the
market also was swept below the 10 and 25 day m/a's and has
turned down on MACD and ADX measures.

It was not materially overbought on my short term momentum
measures, but it was on my advance vs. decline measure (6 week
cumulative) reflecting the strong surge in mid and smaller cap.
issues. Likewise, my 6 week selling pressure gauge has been rising
from low levels for a few weeks, indicating the beginnings of some
distribution.

So, we have a heads up on vulnerability, but my indicators do not
offer strong clues on downside. In total, the indicators suggest there
could be unsettled conditions for up to six weeks. If you had to
make a call, the easiest one would be to say the indices would trace
down to Jan. '10 resistance (See chart).

Top calling in this rally has been like watching Wiley E. Coyote
trying to stop the Road Runner. As I have said for a couple of
months, this rally has been way out of place relative to the steep
advance that preceded it, so I am in humble student of the game
mode when it comes to guessing about whether it can be rescued
or whether a more appropriate and several months long period
of weakness / basing lies ahead. In this regard, one of my top
indicators -- a smoothed 40 week price oscillator -- has whipsawed
me for only the second time in 30 years. When a good one goes
kerflooey on you, it makes you think twice.

Stock Market In Longer Term Context

The stock market panic of 2008 brought the market to its lowest
level compared to its very long term price trend since the 1970s -
early 1980s period when accelerating inflation and sharply rising
interest rates viciously suppressed the p/e multiple. Before that
you can go back to the immediate post-WW2 era when investors
feared the economy would re-enter economic depression. Each of
these three intervals presented great long term buying
opportunities. (I'll never forget being at a Bear Stearns luncheon
circa 1980 when a smart young lady opined that folks interested in
the stock market were mildly retarded.)

The post WW2 bull took about 15 yrears to run to the top of the
long term price channel. The bull run from the 1974 low took 22
years to top the long term price channel before it went into full
bubble mode for the first time since 1927. We then had something
of a mini-bubble running from late 2002 into 2008, before the
crystal chandelier fell to the floor.

The cyclical bull move from early 2009 has been so strong off an
historically low level that we are now only about 15% below
regaining that trend channel top (SP 500 at 1425). This is an
expensive market based on latest 12 months earnings. However,
players are looking forward to $80 earning power on the SP 500
by late 2010 and $100 - 105 earning power at the end of 2011.
Given those projections, it is easy to talk about a 1500 level for
the SP 500 at some point in 2011.

Now, earnings are in a rapid recovery uptrend. But what has really
been most surprising has been just how fast confidence has returned
to the capital markets. Just look at the performance of smaller cap
stocks and junk bonds off the 2009 price lows. I know I was
guilty of underestimating just how fast the BIG money would
regain its swagger in the wake of a near death experience in 2008.

So, the market has experienced an amazing lift-off from depressed,
cheap levels to where it is possible that within 12 - 18 months, the
market could already be in a zone where only exceptional economic
performance going forward would warrant longer term players
remaining on board.

Everyone should feel free to debate return potential for stocks over
the next two to three years. Until I see otherwise, I am in the bull
camp despite seeing the market as overbought currently. Yet, I
would insist we have moved from a low risk / high return market
profile to one that involves above normal price risk going forward.
In short, earnings have to continue very good and inflation and
interest rates have to behave well and moderately when cyclical
forces push them higher or else the market will have significant
vulnerability.

Earnings In Longer Term Perspective

Since the end of WW2, cyclical expansions in corporate profits have
averaged 4.2 years. The band around the average is wide and there
have been observable "double dips" in profits even during ongoing
economic expansions and stock bull markets.

If the current cyclical recovery / expansion of profits meets the
average for the postwar years, then profits could well expand into
2013. The stock market tends to make cyclical tops around the time
profits are cresting. Thus, if the current uptrend in profits is an
average one, it would be fair to say that the stock market would also
make a cycle top in early 2013.

If the cyclical rise of profits is decently normal, then SP 500 profits
could peak around $115 - 120 in 2013, and the stock index could
rise another 60+% from current levels.

The object of this post is not to make earnings or stock market
projections, but to get you the reader to maintain an open mind and
to do your homework as an investor. Look, earnings might grow only
through 2011 before cresting, or profits could expand to early 2016.
Neither development would be a "black swan." In a similar vein,
earnings could experience an average expansion but the p/e ratio
could be sharply crimped by accelerating inflation or, we could
see a little bubble up in p/e on development of a goldilocks mentality.

My own view is that the economy has the potential to expand out to
2016, but that the ride will be bumpy as there is likely to be a
cyclical acceleration of inflation and higher interest rates to contend
with.

But, it is important for you to have a reasonable plan and to be set
to change strategy as your risk tolerance allows when events start
to deviate from plan as they often do. (Risk tolerance is an objective
measure, but it is best defined in terms of each investor's particular
circumstances, both financial and emotional.)

For now, with the economy in the early stage of recovery you should
open up your thinking to include the possibility of much higher profits
over the next few years, even if such a thought seems to be almost
impossibly close in time to the economic free-fall of 2008.

Financial System Liquidity

The Fed wound up its quantitative easing program at the end of Q 1
2010, so we are now seeing a leveling off in its balance sheet, as well
as a flattening out of the monetary base and the basic money supply.
Liquidity in the system is being further constrained by the continuing
run-off of financial co. commercial paper and a drawdown of low and
no reserve jumbo deposits.

Some areas of the banking system's loan book are picking up after
months of decline, including consumer loans, credit card balances
and even C&I loans to business. To fund an expansion on the asset
side of the balance sheet, banks are doing more open market
borrowing for now.

In the short run then, the Fed has left target interest rates unchanged
but it may have just started tightening up on the provision of liquid
balances to the system. From a long term perspective, I would much
prefer to see the Fed be moderately more liberal with the provision
of monetary liquidity, but its foot is off the accelerator for now.
Should the Fed continue with the current liquidity tightening regimen,
My stock market support and long term economic growth indicators
will start to lose positive traction as it would suggest the economy
will grow more dependent on private sector credit creation. These
would be normal non-fatal developments as the economy recovers,
but I regard loss of growth momentum of monetary liquidity as
signalling an upturn in fundamental risk.

It is still a little early to proclaim that short term business credit
demand has turned the corner and is headed up, but a turn does
seem to be getting closer. A turn in business loan demand strong
enough to reverse the downtrend of my credit supply / demand
gauge would be another factor in favor of the Fed raising target
short rates.

Profits Indicators

The corporate profits indicators have been on the right side of a
strong "V" pattern for months. Viewed yr/yr, the indicators are
consistent with both sales growth and profit margin expansion.
This all on top of massive cost cutting done in late 2008 and
through 2009. Estimates for earnings are on the rise as normally
happens in the early phase of an economic upswing. The stock
market is discounting a rapid recovery of earnings out about six
months in time. Projections for SP 500 earnings range from $75 -
80 per share for this year and from $90 - 98 for 2011 (The prior
record high was a restated $91.47 for the 12 months ending in
mid-2007).

If you've been reading the blog for a good while, you know I have
long regarded a big bounce in 2010 SP500 net per share to be an
easy mark to hit. The indicators currently suggest a strong run
for profits well into Q 3 '10 and probably the final Q as well. But,
my indicators are mute on 2011. When it comes to next year, we
are looking at assumptions. To hit the high end of the range for
2011 of $98 per, sales are going to need to grow by 7-8%, and this
in turn would involve the return of broader pricing power for
companies. So, we would need to see a normal full second year of
economic recovery, and we would also have to witness the onset of
fiscal stimulus withdrawal and a turn to a more restrictive
monetary policy with both developments having minimal effect. In
short, the analytical work that has brought us this far constitutes
the easy part of the job when it comes to earnings. Looking well
into 2011 is going to be more tricky.

Technical, Sentiment, Psychology Summary

I thought I had it nailed when the SP 500 dropped sharply over
latter Jan. into early Feb. '10. That break came on time and so did
the rally, but the rally, contrary to historical market behavoir,
developed into a much stronger one than expected coming after
a classic three upleg run from the 3/09 low. I figured we would
see a rally of substance after a good several months had transpired.
I made some money in it, but to compound my frustration, we
are now seeing the upmove extend despite the fact that plenty of
capable analysts / traders have known it was overbought for
at least a couple of weeks. Well, I'll stay with my trading discipline,
but this has been a frustrating several weeks.

This morning at 9:33 am on CNBC, floor commentator Bob Pisani
says, "Folks, there's a wall of money coming into the market...That's
what traders are telling me." So we know sentiment is bullish and
is at extreme levels on a couple of measures. And we also know
that the trading/research/strategy side of The Street has its
swagger back, and that there are a raft of money managers on TV
to tell us the market is cheap on 2011 eps estimates. You know,
guys who were hiding under their desks a year ago.

My ex-post reading on psychology is that with the downward break
in the market into early Feb. there had to be a large number of
money managers who saw a chance to jump on board after the
Greek debt crisis subsided and the economic indicators improved.
These were the guys who were low on equities exposure.

So, all told, this cyclical bull went into fast forward mode timewise,
and even if stocks get dumped for a week or two straight ahead
(it's overdue), I plan to hunker down and trend follow for a good
several weeks before I try to be the first kid on the block to make a
fresh call on direction.

Stock Market & Financial Liquidity

Comparisons between stock market trends and money market
fund holdings did not prove very rewarding for a long while. During
the great bull market from 1982 - 2000, money market funds
experienced dramatic growth as well. There was sizable growth
in total financial system liquidity in the early part of the past
decade, but the stock market languished for a fair part of that
period. That is the main reason I demoted system liquidity
measures as a market tool after 2003.

But, interestingly enough, money market funds -- retail + instit'l --
did reach such a mass size in the past decade, that a positive
correlation between fund flows and and stock market trends has
developed. Money fund outflows were a far better guide to the bull
market that started in late 2002 / early 2003 than were much
broader measures of liquidity.

During the recent bear market, mm-funds increased from $2.3
tril. to $3.5 tril. over the 5/07 - 3/09 interval. That jump rated
out at +52%. Since 3/09, when a new cyclical bull market got
underway, combined mm-funds fell from $3.5 tril. back down to
$2.8 tril. currently. So, about 58% of the cash cushion that was
established over the mid-2007 - early 2009 period has been
drawn down.

Now, it is the stock market that calls the tune here and not the
mm-funds flows. Moreover, the mm-fund data is reported with a
lag, so using this data to time the market will not prove helpful.
We can say that mm-fund outflows are supporting the market
and we can speculate that the well is not yet dry.

I plan to play around with the data in the months ahead, as there
may be some interesting relationships here nonetheless. Here
is a link to the Fed's mm-fund database.

Stock Market -- On Thin Ice Short Term

My rather simplistic view here is the length of time that has gone
by since this rally started in early Feb. is simply sufficient to warrant
a pullback of substance either this week or next. So, I am looking
at the prospect of a small short position.

I am mindful of the many commentators, myself included, who have
pointed out for the past few weeks that the stock market is over-
bought. And, it is. But the progress of the rally has thwarted the
attempts to topspot the market with OB / OS formulas.

So the tactic I plan to follow involves waiting for a clean break of
trend to the downside starting with watching for the market to
crack down and through the 10 and 25 day ma's with enough force
to invite both of the latter to roll over as well. If there is no break
of substance, I'll just keep the powder dry.

Check out the SP500 chart and see what you think. Chart.

Rules Of Road Are Up The Road

The leading economic indicators have pointed to a "V" recovery
from deeply down levels for over a year now. And so we are
seeing stronger retail sales, businesss orders and production.
Next will come inventory restocking, stronger payrolls growth and
more positive income levels. There is substantial pent up demand
and more fuel to support it than many realize. Besides the rapid
and dramatic recovery of profits, there are gains for consumers
from a sizable level of home refinancings and liquid assets held over
in the wake of crashes in auto and home sales. Large sums of down-
payment money were never put into play.

But it is important not to confuse the bounce phase of recovery
from the longer term priorities of economic expansion. So it is
that the initial phase of recovery has oftened concealed the
demand priorities of consumers and business as the economy
progresses particularly as regards the deployment of capital for
longer term purposes.

Thinking Ahead

A surge in the growth of monetary liquidity by the Fed as 2008
wound down set the stage for economic and stock market recovery.
The Fed sat on monetary liquidity for over 10 years prior to the
Great Depression. This time, it sat on monetary liquidity for 4 years
(2004 - 2008) and that ushered in the Great Recession or near
depression. But, now we are in a new and large liquidity expansion
cycle.

Historically, one of the early and major beneficiaries of a sharp,
positive turn in liquidity growth is corporate profits. As we now
see, profits and cash flows for business are surging, so much so,
that private sector credit demand has been slack as financing
needs are met internally.

Now, eventually, as the economy recovers, private credit demand
will grow again and, as tax receipts rise, public sector credit demand
will subside. But, the pressure to contain public sector spending will
not subside and public debt issuance will be further crimped.

However, even as credit needs come into better balance, there will
emerge another consequence of strong liquidity growth, and that
final element in the liquidity cycle is inflation.

There is "action" in the commodities pits, but it would be unusual
to see an acceleration of inflation beyond the volatile fuels and
other commodities components until 2011, when the economy is
further along and more resources are at work. Then, I think, we
could see pricing pressures exert more influence upon interest rates
and the market's p/e ratio, thus leaving the capital markets with
the next major challenges.

So, as you go forward with your investing and/or trading programs,
you will need to monitor not only how well the economy is holding
a recovery path, but emerging inflation potential as well.

Inflation almost invariably begins in the commodites pits with fuels
a primary culprit. In fact, like profits and the stock market, the
broad commodities composites are also often early beneficiaries of
a positive turn to the liquidity cycle. As rising commodities prices are
absorbed into the economy as costs, the groundwork for a broader
spread of rising prices is set.

Economic Indicator Issues

with the economic recovery moving along, I am skipping the usual
detailed commentary to focus on a couple items of strategic interest
to the capital markets.

First, the group of weekly and monthly leading indicator sets I
follow are progressing, but we'll have to watch over the next
several weeks to see whether the indicators are at momentum
inflection points and whether further advances will be more
moderate. More moderate progress for the indicators would be
the normal development. What's interesting is that it is not clear
that we are there yet. This applies to global as well as US measures.

Secondly, with the pace of shrinkage in the banking system's short
term business loan book moderating and with non-financial top class
commercial paper demand rising, total business lending may be
nearing a positive turnaround. In fact, with the stronger market for
industrial commercial paper, my indicators behind whether the Fed
should raise rates have moved up from 30% to 50% in favor. This
development raises the "buzz" level on The Street re: Fed policy
as does today's news of an increase in payroll employment. The
weakness seen in the Treasury market in recent sessions reflects
sector swap rotation to pick up yield, but it could also reflect
"handicapping" on an eventual reversal in Fed policy.

Finally, the inflation pressure guides I use did level off early in
the first quarter of 2010, but with the strong action in industrial
commodities and petrol, these gauges may be firming up again.

Stock Market -- Short Term Technical

This post is an exercise in due diligence. Short term consolidation in
the stock market has taken it off the uptrend line in place since the
2/5/10 interim low and left it just a smidge above the 10 day m/a.
So far, what we are seeing is a work off of a sizable short term
overbought condition which can be rescued easily enough. Even so,
I pay homage to the break of trend and the market's proximity to
the short term m/a's. I also note that the 9 month cycle rolls around
in mid-April and that a shorter cycle also has a low around the same
time. As always, remember that cycles shift and fail, but deserve
respect nonetheless.

There's a three day weekend ahead for the market, and with
employment data due out on this Fri., there may be position
squaring underway currently, as only the SP 500 mini will be open
and that only until 9 am. As well, with tomorrow being April 1,
the quarterly window dressing is done. Thus, I would be looking
toward next week to see if the rally may be rescued or not.

SP 500 CHART.

Gold Price

I last discussed the gold price back on 11/20/09. I claimed it was
very overbought but could have a blow-off spike up into the
high 1200s before settling back to $950 in the spring of this year.
Gold did get up toward $1240 oz. in late '09 and did settle back to
$1050 in early Feb., but it has moved up some from there in recent
weeks.

Gold is now struggling to hold its uptrend rolling back to late 2008.
It has broken the trend twice this year, but the breaks have been
modest and you have to give a volatile medium like gold some "over
and back" chances around a trendline before you can say with
authority that a downside break has occured.

My gold macro-directional indicator has been rising pretty steadily
and strongly since the latter part of 2008. The monetary
component rose sharply over the past 15 months, but is very likely
to settle in to a much more modest trend as major central banks
rein in quantitative easing and special lending programs . Thus,
for its strength, the gauge will be more reliant on the pricing of oil
and a basket of industrial commodities as we move forward through
2010.

Updated fundamental research on gold mining now pegs the all in
cost of extraction at $700 oz. for new mines. I have used the new
data to reset my micro indicator for the value of gold up to $650 oz.
and may adjust it higher if the global economy continues to expand.

I continue to regard gold as very expensive and will likely only
play it on the short side from time to time. CHART.

Stock Market -- Valuation Benchmarks

Last of a three part post on market fundamentals.

The SP 500 Market Tracker based on 12 months eps through

3/10 sits at 1060. The market is currently trading at a 10%

premium to the Tracker. The spread is not onerous.

With rebounding earnings and rising estimates, the market is

discounting continuing strong net per share performance into the

third Q of 2010. Again, not unusual.

The Tracker, based on a full year consensus estimate of a touch

over $78 per share, would fetch a value 1290 for the SP 500 by

late in 2010. Since advance indicators point to sharply rising

recovery eps into Q 3, this is probably a reasonable enough

projection.

So far, investors are showing no concern about the issues of

exiting accomodative monetary policy and strong fiscal stimulus.

Both issues could arise as concerns later in the year.

The Market Tracker based on super long term trend earnings

gives a "500"value of 1155 for 2010 and 1230 for 2011. So, for

investors with a longer term time horizon, the market is now

fairly valued. This means that the chances for sizable excess

returns depends entirely on continued strong earnings gains and

a moderate level of inflation (not in excess of 3.5% per).

I also use a simple dividend discount valuation model and a

kindred p/e assessment model based earnings plowback. The

dividend discount model reveals that investors are expecting a

cyclical recovery of the dividend and that players are also

factoring in earnings / dividend growth of between 7.5 -8.0%

long term. From an economic perspective, this would imply

top line growth of 6.0 - 6.5% plus further profit margin

improvement. That would represent a tall order if the USA was

the exclusive focus. So, implicit in investor's minds are continued

aggressive balance sheet management such as share buy-backs,

and the benefits of increasing SP 500 exposure to faster growing

emerging and developing economies with lower cost structures.

Clearly, investors do not have humble expectations.

Over the past 20 years, companies have allowed dividend

payout ratios to decline and have increased the ratio of earnings

plowed back into the business. Return on Equity % x earns.

plowback rate = implied internal growth. Excluding the recent

recession years the formula would run as follows: 15% x 65% =

9.75%. That would imply a p/e ratio over 20x trend eps.

Investors, seeing that few companies can grow by over 10%

a year, have not bought into the corporate strategy since the

bubble days of 1996 - 2000. And, they have been correct to be

more conservative. In fact, I suspect that earnings and market

performance for the SP 500 would have been more stable had

companies payed out more in dividends than they have.

Stk Market Fundamentals -- Indicators

Second of a three part post on market fundamentals.

Core market directional fundamentals have been positive since
late Dec. 2008. This group includes measures of monetary
liquidity, market short and long term interest rates and
confidence indicators. These are my "easy money" measures,
both in terms of betting with an accomodative Fed at your back
and the opportunity for a high return / low risk long side play.

Core indicators turn decisively negative when restrictive Fed
policy chases up short rates and corporate yields, curtails
basic monetary liquidity growth and starts to bite into my
favorite confidence measures. That process has yet to start.

When the "easy money" period ends and a more restrictive
policy is adopted by the Fed, the market may sell off some, but
can recover and go right on up. But this type of situation offers
moderate return for steadily increasing risk. It is a time to play
with a substantial and rising liquid reserve kept aside. I am
developing a couple of indicators for increasing business cycle
risk keyed on the 91 day T-bill and measures I use to determine
when corporate earnings are nearing a peak. More on this at
another time.

True to form, the 3/09 - 9/09 period was an "easy money" run.
I played it full out, but have been in on the long side more
sparingly since, simply because the advance was so strong and
I was concerned players would be far more nervous than they
have been.

Secondary indicators remain negative. the real price of oil has
found a less ominous upward trajectory, but a continuing
advance forms a headwind for economic growth. Also, with
the broad economy advancing and the broad measure of credit
driven money growth declining, liquidity available for the
stock market is shrinking.

The market has done somewhat better over the past 6 months
than I thought it would. The trajectory of the advance has been
unimposing, but it has been strong enough so far to raise a
doubt whether the negative secondary indicator readings have
created much of a headwind.

Stock Market Fundamentals -- Earnings

First of a three part post on market fundamentals.

The recovery of profits began when expected, and has been strong
to date, also as expected. The initial surge of the recovery was
heavily influenced by cost cutting and the lower weight given to
failed major companies in the SP 500. Net per share just topped
$57 in '09 and about $10 of that reflects a much lower cost
structure going forward.

The lead indicators for profits suggest a strong recovery trend
well into Q3 '09. There is good potential for further improvement
in profit margins as higher sales and operating rates generate
efficiencies via rising productivity and even betters spreads over
fixed costs.

Analysts are raising earnings estimates as the ecoonomy progresses.
This is a normal development. So far, estimates for 2010 have been
increased by $3 per share or 4% for the SP 500.

The $ cost of production, a decent proxy for business sales, is in
an upswing and was up 3.8% yr/yr through Feb. Measured yr/yr,
profit margins tend to expand cyclically when the $ cost of output
exceeds 5%. The volume of recovery in goods and services this year
should exceed 5% over 2009, even without taking pricing into
account. Right now, pricing power remains narrow and limited
overall.

Analysts project SP500 net per share to top $78 this year, but that
number could well be bumped up to $80 over the next month or
two. The $80 figure compares to the revised record for 12 month
eps of $91.47 set in mid-2007. Sp 500 net per share on a 12 mo.
basis first topped $80 back in 2005.

At this stage, one should take 2011 earnings estimates as they come
out with double the normal grains of salt. This is because the US
and other major economies have been supported by the largest
fiscal and monetary stimulus programs ever, and because the
authorities will feel increasing pressure to exit these programs as
recovery progresses. Numerous program exits starting in late
2010 and running through 2011 will prove a drag on global growth
even if economic recovery is fully self sustaining.

Corporate earnings growth has accelerated over the past 20 years.
Companies manage balance sheets far more aggressively than
ever before. Strong pressures to boost performance have led to
higher profit margins and return on equity %, but have led to
ever greater volatility of cyclical performance as companies shed
losers and mistakes during downturns. As a consequence, ROE % is
up, but growth of book value has been stunted. Moreover, faster
growth is less appealing when growth visibility is reduced.

Financial System Liquidity

The banking system continues to contract as banks let loans roll off
the books and boost Treasury and other investment holdings. Thus,
banking system liquidity has improved sharply. The banks are still
recording a high level of loan loss reserves, although the momentum
in the system account is slowing. Businesses -- flush with cash --
have been steering clear of the banks and are using internal resources
to finance recovering sales. Businesses in desperate need of cash are
simply out of luck. Top quality borrowers with direct access to the
nonfinancial commercial paper markets do not seem to be paring back
further.

Over 90% of the increase in banking system primary funding levels
reflects growth in currency and checkables and this is directly
attibutable to Fed quantitative easing. The Fed is looking forward to
cutting back on this policy, but wisdom suggests that the situation
with bank private sector credit creation stabilizes first. (Keep in mind
that the basic money supply accounts for only 15% of primary bank
funding and that the Fed, rather than being profligate, has been
battling to curtail a deflationary contraction in private sector credit.)

Money market funds, both retail and institutional , are used to finance
capital markets transactions as well as purchases of goods and
services within the real economy. These balances built up sharply over
2005 -07, but have since been in substantial drawdown mode. Thus
liquidity from this sector although remaining substantial, has been
pared back.

The real economy is growing and the very broad measures of financial
liquidity have been declining modestly. Thus, by my approach, the
capital markets now face a headwind from reduced liquidity as the
real economy takes precedence.

The economy does tend to lead the broad measures of credit driven
liquidity in the system. As the economy continues to recover, it is
likely to become more credit dependent, which can, in turn, lead to
more liquidity on hand to finance the capital markets as well.