Steady As She Goes

Since the lows of the stock market back in March, the market has given investors a very nice rally. As we entered the start of Fall the market began to waiver. While the general indices continued to rise, it was the most aggressive investors who were benefiting. "Government backed" companies like Citibank and Bank of America continued to rise, while others, like Research in Motion, started to feel the realities of an economy that is still very slowly recovering.
Dallas Federal Reserve Bank President Fisher suggested that the Q3 real GDP print will be taken down from 3.5% at an annual rate to 2.5% — despite massive government stimulus. (Is that all you get for your money?) And the Philadelphia Fed survey of professional forecasters shows that this collection of 41 economists just took down their 2010 Q1 GDP call to 2.3% from 2.5% and for next year's Q2 to 2.4% from 2.8%.

Meanwhile, the S&P 500 is currently trading as if the economy is going to expand at nearly a 5.0% rate in the coming year. If the consensus is right, then fair-value in the S&P 500 is closer to 900 than it is to 1,100. This by no means suggests that the speculative run is over; it only means that the folks allocating their capital to the stock market today do not adhere to the adage of ‘buying low and selling high' and are very likely the same folks who were buying at the top back in 2007 when "excess liquidity" themes were all the rage.
So does this mean we should all back our bags and head for the hills? Well, not yet.
The continued rise in the stock market has been due to two main factors. One, the massive amounts of liquidity. Interest rates are at zero and as banks begin to issue more loans companies can restructure their debt and upgrade their equipment -making those companies more efficient and productive. As the economy recovers these companies will be able to take off, like a well tuned race car.
The second factor is the government backstop, as I like to call it. For the economy to recover, banks need to play a big role in lending. For banks to lend they need money and they need to be well capitalized. There are two ways to do this. One is for the government to just give banks lots and lots of money. (Tried that and it didn't work)
The other is to have banks create their own money. How do banks do this? Companies like Bank of America sell their shares to investors (via secondary and preferred offerings). Since nobody wants to buy shares of a $1 company, the government will do everything in its power to get the stock market healthy, since investors are more likely to buy the stock of a $15 company.
This circle of life becomes the government backstop. And both traders and investors know that without a backstop in place, the banks will go out of business and the economy will collapse.
Case in point. The first week of November the volatility in the market increased by over 50%. The S&P 500 broke an important trend line that market technicians follow closely (see chart 1). With a combination of a break in trend and the continuing news that the economy is not recovering as fast as we would like it, the markets looked like they would finally take a breather.
However, as investors realized that once again the government would keep a backstop in place, they came back to the market. Market breadth was over 9:1 (a very bullish sign) and volatility returned to previous levels.
What does this mean going forward? The markets (and media) seem to be focused on only looking at the good news. As the holiday shopping season has nearly begun, the government will try its hardest to keep the stock market rising as happy investors mean happy shoppers. Retailers need a successful shopping season and the government is going to give it to them.