Stock Market Fundamentals

The SP500 Market Tracker is about 1550 for March,'07.
The market is nearly 9% below the Tracker at 15.9 x
expected 12 mos. earns (through Mar.). With lower
inflation since mid-2006, the market should be at 17.5x.
The worry is more about the earnings outlook than
inflation. Earnings estimates have been cut, and first
quarter net per share could come in only 5% above prior
year for the "500" and below the Q2 '06 level.

The market model based on the monetary base remains
positive, but the appreciation in the market since the
end of 2005 is considerably stronger than the model
suggests. This is no longer an uncommon development and
reflects investor attention on the growth of credit
driven liquidity which had been accelerating steadily
until just recently. There are a couple of factors worth
noting here. First, money and credit growth most closely
tied to transactional demand within the economy has
slowed appreciably this year. Secondly, with bank funding
needs having eased some, broader measures of money growth
are slowing, especially finance company sales of asset-
backed paper (reflects slower economy and sub-prime mortgage
fiasco).

As I have discussed in a number of posts, the economy can
be very vulnerable once credit driven liquidity starts to
slow or recede, AND if the Fed chooses to let it unwind
and not add reserves to the system in a decisive manner.
The US is at that point now. It is a high risk point in any
US business cycle.

So with earnings estimates coming down and liquidity at issue
investors have moved to discount the earnings cuts and ponder
whether the shallow dip in the road might be a prelude to a
valley.

It would be a breeze here for the Fed to ease if capacity growth
was accelerating nicely and a dose of monetary liquidity would
push the economy into a higher but more balanced growth mode.
Such was the case in 1995 -- the last big "soft landing" play.
It is not the case now, as capacity growth continues to lag that
of demand growth potential. To ease now, the Fed would be
gambling not only that productivity growth would soar, but that
capacity growth would finally accelerate. Perhaps the FOMC will
shed some light on this issue at tomorrow's meeting.

I came into 2007 cautious on the stock market and I remain so. The
absence of balance between economic supply and demand remains and
continues to leave me with more questions than answers.