The best explanation of the strong capital market performances is a general investor expectation of a recovery in earnings. The best explanation of the poor performance in the risk free Treasury bonds is either a return to normal yield level after the panic in the fourth quarter of 2008 drove the 10 year Treasury bond to an all time low, or an investor expectation of an increase in inflation. I agree with a recovery in earnings (but not personal incomes) and I disagree with an increase in inflation. The 10 year Treasury bond simply returned to its pre-panic yield level of around 4%. We will examine these in detail, but first lets look at the winners list. The Walking Wounded Were the Winners! In a normal venture capital portfolio of ten investments, there will be two big winners, one or two losers and the rest are walking wounded not winners and not losers but somewhere in between. The top 10 S&P 500 Stock Index price performers are weak companies, such as Ford, AMD, Genworth Financial, and Micron Technology. Only one of the top ten pays a dividend. Except for Western Digital, all have either reported losses in the past year or have low or negative net worth. Some, such as AMD and Micron, are consistently unprofitable. Heres the list: Top Ten Price Performers 
Right now there is a lot of media clamoring about the Federal Reserve Banks balance sheet expansion. The Federal Reserve Bank has borrowed $2 trillion in the past 18 months. About $1 trillion was used to bailout various financial institutions and companies. The banks that received government bailout money, mostly large bank holding companies, did not make loans with it. They put it back on deposit with the Fed. In short this huge amount of created money has not gone into the economy. It remains on deposit with the Fed, and at some point, the deposits will be drawn down to repay all of the bailout loans. So the Fed borrowing is not as excessive as some claim. If we take the $1 trillion in deposits out of the M1 amount shown in the chart above, the money supply drops to below the GDP (red line) , just like it has been for the past 10 years. No More Railroad Tracks This next chart illustrates the close relationship of growth in the economy (Gross Domestic Product or GDP) and growth in the money supply (M1). For a long time GDP and M1 tracked closely, almost like a set of railroad tracks. But the dramatic acceleration of inflation in the 70s and the slow but steadily increasing involvement of the government in the economy have caused this relationship to be disturbed. 
This chart shows the long term relationship between the economy and the supply of money needed to run the economy. The multiple is about 10 to 12 times. That is, the sum of economic activity (GDP) can be adequately financed with a money supply equal to about 10% to 12% of the GDP. This multiple varies from time to time, especially since 1990. The chart above suggests the current money supply is about in line with the long term relationship of GDP to M1. As you can see, for the past 30 years, the money supply has tended to deviate from the GDP. In times of recession, the Federal Reserve Bank (the Fed) injects more money into the economy in an effort to decrease the severity of any downturn. Some will argue this has been a successful strategy. That may be true but not part of our discussion now. The point is the money supply now regularly diverges from the GDP. It has happened for the past three recessions. The Federal Reserve increases the money supply until the economy recovers. It then withdraws this liquidity from the system as the economy can now grow without as much money. The Fed dramatically increased the money supply in the recession of 1991 (the blue line shoots up). Then from about 1993 until 2001 the money supply was constant (the blue is flat). This means there was no change in the amount of money in the system as the economy grew from 1993 until 2001. Again in the recession of 2001 2002 the Fed expanded the money supply and then held it constant from 2003 until the middle of 2008. And now it has expanded the money supply again. The Fed will repeat the pattern of past recessions and recoveries. It will withdraw liquidity later this year or in 2011. Now lets compare the changes in the money supply with inflation (CPI).The following chart shows this relationship for the past 60 years. 
As you can see big changes in the money supply have caused virtually no change in the rate of inflation. The biggest increase in inflation was in the mid to late seventies, which saw almost no change in the money supply. So a dramatic increase in the money supply, like now, does not automatically lead to higher inflation. There does not seem to be a strong connection here, does there? But the argument for low or no inflation for 2010 is stronger than just the lack of a relationship between M1 and inflation. Huge Surpluses In addition, there are vast idle resources available that also argue for little or no inflation. After all, inflation is the result of too much money chasing too few goods. We dont seem to have too much money and we have lots of idle resources. We have surplus cash, surplus production capacity, surplus workers, surplus real estate, and surplus energy. Surplus of resources would argue for no inflation, or even deflation. Offsetting this constraints are two factors that boost inflation. The first is the automatic increases from COLAs (Cost of Living Allowances) and the second is strong pricing power from companies producing products people want, such as iphones and Lipitor. Surplus resources offset by automatic increases means inflation will be positive this year just like it has been every year for the past 40 years. I estimate it at 2%. Households Are Holding According to the Flow of Funds Report issued by the Federal Reserve every quarter Americas households are flush with cash. They collectively have $7.7 trillion in liquid financial assets representing 15% of their net worth. The amount has doubled in the past decade and the percentage is at a 20 year high. Bank deposits and short term CDs pay almost nothing. These funds, at least a portion of them, are available for investment that earns more than nil. Some of this liquidity will be invested in the capital markets this year. Factories Are Waiting Last fall our factory utilization rate hit a new low of 68%. This means only two thirds of our factories are working. The remaining third are waiting. Capacity utilization is very volatile and responds rapidly to changing economic conditions. It falls in recessions and increases during economic expansions as the red line in the chart below illustrates. The troubling part is this line is trending down over the past 40 years with lower highs and lower lows. The blue line is an index of factory capacity. As you can see it grew steadily in the seventies and eighties, accelerated during the Reagan years. For the past almost 10 years capacity has stagnated. In short we are not adding any new factories. This is also troubling. The fact remains, about one third of our factories are idle and available. 
Workers Are Idle In this past recession we also created a vast surplus of workers. When the recession began America employed 138 million salaried workers. Two years later we employ 131 million. Seven million people who were working and probably want a job are unemployed. The following chart shows this dramatic fall in employment (blue line). The interesting point in this recession is the average wage continued to increase. This is strange and troubling for the outlook for unemployed workers. In the prior recession the same thing happened. Employers laid off workers and average wages increased as the recession unfolded. The outlook is for employment to continue declining for some time just as it did in the 2001 thru 2003 period. Because of the ever growing burden of federal taxes and employee benefit costs I expect employers to hire slowly. We should see overtime hours spike significantly before we can expect much more employment. In 2009 overtime plunged to a 30 year low. This is not a good sign. The alternative, of course, is for the government to decrease the cost of hiring. 
Houses Are Vacant We all know whats happened to real estate. The value of our homes has declined as never before, down 50% in some locations. The real estate boom created 13 million houses that were not homes, and probably never will be. Foreclosures are hitting record levels and mortgages are difficult to get. The housing overhang will exist for some time. We can expect housing related industries to struggle for survival. Please read my piece entitled, What Recovery? What Recession? for a more complete description of the housing bubble. Energy Is Abundant America imports about half of the petroleum it uses. Not only does this hurt our trade balance, it is not necessary. According to the Congressional Research Service, a part of U.S. Congress, we have more reserves of fossil fuel than any country on earth. The report is titled U.S Fossil Fuel Resources: Terminology, Reporting, and Summary and was released October 28, 2009. Go to www.opencrs.com to download this report. It is simply a political decision not to access our own resources. Lots of cash, empty houses and factories, idle workers, and ample energy resources argue for little or no inflation. What About Earnings? Valuations have become extremely extended. The S&P 500 Index has a price earnings ratio of 91 times and a dividend yield of 1.9%. Other indexes are not so extreme. The Value Line Index is 17 times earnings and a yield of 2.1%. The Dow Jones Industrial Index has a P/E of 18 times and a dividend yield of 2.6%. Price Earnings ratios are high and dividend yields are low by historical standards. The following chart was prepared from information available at Standard & Poors website. The first two columns show the year end price of the Index and the percentage change for the year. The next two columns are the actual operating earnings each year and S&Ps forecast for 2009 and 2010. I have used operating earnings, which is very different than net earnings. Operating earnings are a better indication of how a company is performing. Net earnings can include many one time charges that greatly affect a companys earnings. In short, net earnings are much more volatile than operating earnings. The last column is the price earnings ratio. S&P 500 Index Historical Data and Forecast 
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