Stock Market

Since the end of 2011, SPX net per share has moved up a little over 17%. The market has soared
though with investors adding a little over 4 multiples to the p/e ratio to bring it a touch over 17x
latest 12 mo. earns. This jump in valuation constitutes a major upswing in market player
confidence. The key driver appears to have been the Fed's ZIRP on short rates and the provision
of ample liquidity. Looking back to the close of 2011, it took nearly two years for these policies
to breath life into the progression of of earnings, which appears to be on a stronger course in
2014. Now, the Fed is steadily unwinding the big QE 3 program, and with better business
performance and rising credit demand, has taken to suppressing short term rates to hold the
ZIRP at least until the easing program is fully zeroed out late this year. Measured yr/ yr,
total system liquidity growth is still very strong relative to economic progress but the liquidity
situation is likely to continue deteriorating well into 2015. The private  financial sector has
stepped up to provide more liquidity in the form of credit, but, as it does so, the hawks on the Fed Board will greatly increase pressure to end the ZIRP and raise rates.

Inflation has decelerated substantially since 2011, and with the economy progressing modestly,
investors have cut the rate at which they discount future streams of earnings and dividends. This
too, has allowed the p/e multiple to expand. Now, typically when there is rapid growth of
liquidity, profits respond but so does inflation with a lag. There has been a mild pick up in
CPI momentum recently but not enough to be troublesome yet.

From 12/11 through 12/13, the SPX compounded at a nearly 24% annual rate. The market is
up this year so far but it is running far below the 24% rate and many smaller stocks are down
on the year.

With net per share growth stronger, and monetary policy in transition away from super
accomodation, it is logical to expect p/e ratio contraction well into 2015, unless of course
investors want to press the advantage of a lengthy transition in monetary policy toward
normalcy to full if not reckless advantage. The fundamentals are very good now, but are
headed, gracefully I hope, downhill.

I have continued to regard the gradual reduction of the QE program as an experiment with
risks to the market and the economy and not as a done deal transition to a smooth continuation
of the economic expansion. I watch economic momentum very closely.