What next for the market?

Investors continued to chase the market higher, with the S&P 500 making fresh 2009 highs. Market participants have clearly discounted in solid GDP performance for the current quarter, but several big question marks are looming as market participants are ready to wean the U.S. economy off of government support.

Ending this week is the guarantee for the $2.5 trillion money market mutual fund industry, which was meant to prevent a run on the nation’s banks after one fund “broke the buck.” In October, a program that guarantees new debt issued by financial companies is set to wind down. This helped banks roll over their debts while embellishing their earnings. Markets do, in fact, seem ready to have their training wheels removed, but are they ready to ride alone?

The consequences are less certain for the removal other programs whose size and distributions of benefits are a bit more opaque. For example, to what extent have federal purchases supported the MBS market, and how will investors behave when support is withdrawn? Will the market for securitized consumer debt freeze up as the term asset-backed securities loan facility winds down, and will this event directly impact consumer spending?

Speaking of the consumer, no doubt spending has received a shot in the arm from programs set to expire by the year’s end, such as Cash for Clunkers and the $8,000 housing tax credit for first-time homebuyers. Are we simply borrowing future demand to spur sales at the present?

All of this uncertainty makes it easier to accept the arguments for equities being overbought. Driven off its March lows by low yields available on cash and government bonds as well as hopes of economic recovery, the S&P 500 has rallied more than 57%.

Sure companies have handily beaten their earnings, but these estimates were radically lowered heading into the reporting quarter and did not result from sales growth. In addition, global growth has been inorganic and more a result of government fiscal stimulus. And while profit margins have improved, they will likely come under pressure if all the workers being fired in order to maintain profitability spend less and less – not to mention consumers with jobs that are constrained by debt burdens and lower wealth.

Any prospect of lower profit margins makes the S&P 500’s valuation seem even scarier. Today, the S&P 500’s valuation stands at 19 times trailing earnings and 18 times on a normalized trailing 10-year basis – a lofty level normally associated with boom conditions. But if the recovery hopes do not translate into the robust profit recovery the market has priced-in, then it is hard to see how the rally can last.

Of course, market valuation is a poor device for timing a correction since equities have historically remained overbought for extended periods of time. After all, markets have a large degree of self-fulfilling prophecy and a positive feedback loop can do wonders for the market’s direction. And the wall of worry that stocks are climbing is key to the strength of sentiment for the rally.

Still, it’s difficult to ignore the inflated growth assumptions and increasing risks present in today’s markets.

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Peter J. Lazaroff, Investment Analyst