I, for a long time have been surprised with the strength in the Dow and the S&P. I see no reason for both being so high with all that is going on in the world. In my own unsophisticated analysis I have felt that a severe decline in both the Dow and the S&P are inevitable .

<throws up hand>

I know, I know!!!

Well, at least I think I do. Central banks have driven interest rates down to the lowest levels in decades. There's a number of reasons for this, but the effect has been to make stocks more attractive relative to bonds. With yields in the 3-4% range, and inflation running over 8% (you don't really believe CPI right? Ask your wife what the real inflation rate is.) you are effectively losing money in bonds, and that doesn't even cover the loss to foreign investors from the decline in the dollar.

Why do I mention foreign investors? Because they have a lot of dollars to invest - dollars they got from manufactured exports (China) and from the sale of oil (OPEC). This money has to find a home. Much of it went into bonds over the last few years, which partly explains low interest rates (bond price up = yield down) but much of it has gone into stocks, which helped put a floor under share prices.

Huge international dollar surpluses (the flipside of the US trade deficit) have to go somewhere. Sovereign Wealth Funds, which are national investment funds created by dollar surplus nations, such as China, Saudi Arabia, Norway etc. have been buyers of US stocks. More specifically, those companies in the Dow and S&P that derive substantial earnings from overseas, and are thus buffered against the decline in the dollar.

I'm not arguing that share prices can't collapse, but ultimately the money has to go somewhere. So, where would it go? Into overheated foreign economies? Into overpriced bonds? Gold? Commodities?

My argument is that, as long as central banks are expanding money supply at double digit rates (this is true of all central banks today) that money has to go somewhere. So, it is possible to have stocks rise in nominal terms, thanks to new money creation, even though their inflation adjusted price is losing ground in terms of purchasing power.

One way to gauge the effect is to examine the S&P500/oil ratio. This tells you what a unit of S&P500 costs in terms of oil. You could do this with eggs, milk, bread, any commodity for that matter, but since oil is fundamental to all production, it's a good proxy. What this ratio reveals is that while rising in nominal terms, stocks are losing ground relative to oil, and by implication, everything else you have to buy to either live (milk bread eggs) or invest (oil, materials, labor).

I don't rule out a major decline in stocks. I'm just trying to point out why they've held up so well in the face of falling earnings and rising costs - the typical metrics fundamental analyists use to determine share prices. Clearly there's a disconnect here, and I believe it's mainly the result of central bank monetary inflation. Not an argument to own stocks, just a possible reason why they haven't gone down hard in the face of all the obvious negative factors you'd expect would produce that result.

ebear