Will the Fed’s Spending Drive Stocks Back Up to Pre Credit Crash levels?

By: Money_Morning

Jon D. Markman writes: The Standard & Poor's 500 Index is up more than 10% in the past month, and it finally looks like all of the thin threads of strength we've seen over the past few months are starting to twine together into a single rope that may be strong enough to pull stocks back up to pre-crisis levels.

The key threads are:

•The ECRI Weekly Leading Index has stabilized and turned higher.
•The U.S. Federal Reserve announced that it had made an epic change in its outlook, targeting deflation instead of inflation.
•Emerging markets and commodities are leading other markets higher, as we have seen for two months.
•Demand for stocks has increased while supply has decreased.
Even if you are skeptical of these developments, remember one thing: The Fed has absolutely flooded the financial system with money.

Banks and large companies have hoarded most of those funds so far, leading gross domestic product (GDP) growth to stall. But the Fed essentially said last week that it is going to double down. The central bank has never had a $1 trillion balance sheet, but it could have a balance sheet twice that size by this time next year if it goes through with its plan.

This money ultimately will be put to productive use, and eventually, it will leak out into the stock market as speculative investment and nurture inflation.

My guess is that any decline from here will be shallow because the central bank has issued what traders are calling a "Bernanke put" - a takeoff on the "Greenspan put" that was believed to underlie the market in the 2000s.

A put is a derivative that swells in value if its underlying instrument goes lower in value. So the idea is that if the economy goes lower, Bernanke's efforts to save it will get larger. This should create a cushion of safety - real or imagined - especially if it is increasingly seen to be "at the money," or triggered by near-term events.

We can mutter about it under our breath and wonder if it's the right thing to do, but it's happening nonetheless. So what I want you to grasp is that the greatest financial bubble in the history of mankind is being formed right in front of our eyes. And the only sensible thing to do is take advantage.

The prospects for the S&P 500 to return to its pre-crisis levels above 1,200 - its level prior to the September 2008 Lehman Brothers Holdings Inc. bankruptcy - are better than ever. In fact, it would not surprise me in the least to see the entire U.S. bear market repealed by the end of 2012. It already has been swept away in many overseas markets, so it's just a matter of time before it happens here.

Skeptics say that the Fed is "pushing on a string" with its plan to flood the system with money because there is not enough demand. But that concern ultimately will vanish as entrepreneurs - enticed by reward and propelled by ambition - will find ways to put the money to work.

It happened in the 1990s, when the Fed flooded the system with money in the wake of the late-1980s savings-and-loan crisis and 1990 recession. Investors were skeptical in the first few years, but the markets ultimately increased five-fold by 2000.

You may recall that period began with the Internet being strictly used by academics and the military, and ended with an incredible boom of the consumer web, which led to billions of dollars in wealth creation and tens of thousands of jobs. However, we are currently in the midst of a commodities bubble that is similar in scale.

Just to get an idea of what I'm talking about consider this anecdote: One of my hosts in Pittsburgh told me about the business of his son-in-law in Lansing, Michigan. The young man graduated from high school a dozen years ago and went to work for his father's tool-and-dye business as an apprentice. Before long he was a master toolmaker and took over the business.

When the recession and credit crisis hit, his local bank was taken over by a larger national bank that decided to pull his line of credit. That would have been fatal to a small company that often had to buy equipment before it could bill for the products that it would create. But the young man didn't fold; he was resilient. He persuaded another local bank to give him credit, and after several lean months discovered that one of his biggest customers, Pratt & Whitney, had won major new bids of its own to supply engines for jets that were sold to Asian and Persian Gulf customers suddenly flush with money from the commodities boom.

That small business is now on track to hire a new employee a month, and expects to be able to more than double its business next year.

So you can see where I'm going: Rise in commodity value = more money for commercial airliners in under-served emerging markets = demand for more engines = demand for more parts = improvement in financial condition of a Michigan manufacturer = more skilled jobs in Lansing = more money to buy houses and cars and spend in restaurants. Several major industrial manufacturers, like The Timken Co. (NYSE: TKR), are already at new highs.

I realize that this may be overly simplistic, but it's real.

Sometimes investing decisions are hard, and sometimes they are not so hard. Right now it's the latter. The Fed sees weakness in the economy and employment, and has vowed to fight them. It has never lost such a battle, though sometimes the effort is prolonged.

More simply, the price/earnings (P/E) multiple for companies in the S&P 500, such as Johnson & Johnson (NYSE: JNJ), is around 13. Given the current level of inflation and interest rates, the average PE of the average large company should be 20-times, and some sober, veteran investors and academics argued over the weekend at a major economics conference organized at Princeton University that it should be 25-times.

This means that prices should be twice as high right now, all other things being equal. That's a bit extreme, but you get the point. All that is missing is a return in confidence - and that should not remain scarce for long.

Source : http://moneymorning.com/2010/10/06/stocks-3/

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