Why Won't This Market Go Down?

The fundamental reason why this market may not go down (when for all intents and purposes it probably should) is because there are still plenty of investors still sitting on the sidelines just waiting for it to fall to get back in.

I hate the idea that the market level is in fact set by supply and demand rather than fundamentals. But you would argue that supply and demand are a part of fundamentals. Yes and no. Yes in the sense that the market is simply a market with prices set by supply and demand. But no in the sense that the market does not always reflect the fundamental economic reality of an asset.

When supply and demand are more a function of sentiment than economics, then perverse outcomes tend to happen.

What Drives Equities

Over the long term equities are driven by two things. One, fundamental and the other sentimental.

The Fundamental
The fundamental driver of equities values is earnings. Earnings are a function of revenues (demand), margins (efficiency) and tax regimes. Earnings may vary over time, but trend positive.

The Sentimental
The sentimental driver of equities values (which is to some extent and at different times more important than earnings) is the multiple. What the market is prepared to pay for earnings at any particular point in time. It is a function of confidence and risk. The multiple the market is prepared to pay for present (and implied future earnings) varies from a high of 35x to a low of 8x.

Since bottoming in 2009 the market has been propelled by substantial earnings recovery and earnings growth ($30 EPS to $115 EPS), and by multiple expansion (11x to 16x). With earnings plateauing, future market performance is likely a function of multiple performance. If the multiple goes from the present 16x to 20x then the market can rise to 2300 (30% above the present level). Projecting earnings is relatively easy (or if not easy, more stable). Projecting multiples is a lot more difficult.

Breakout

Technically we broke out earlier in the week, but then we went back and tested the new support line. Today's big move is a confirmation of the breakout and is likely to draw shorts and cautionaries back into the fray. A comment by David Tepper that we're in a win-win situation (if the economy recovers, the market goes up, and if the economy tanks, the Fed will intervene and the market goes up), looks to have got things going. Volume is still enemic, but breadth is humongous. Even though we may be entering a new range, I doubt we're out of the woods and this could all be a little premature. Having said that, if the market gets its courage up, it could have a real nice end of year rally.

If you're looking for a fundamental spin on the breakout, about the best I can surmise is that some of the leading edges may have started looking beyond the current soft patch, and are anticipating greater recovery in the future (leading to sustainable earnings growth and expanding multiples). Right now, all we have are expanding multiples (risk on).

A Problem, an Issue, or a Conundrum

Actually it is probably more an issue and/or a problem, rather than a conundrum.

I am referring to the fact that financial markets like gold and oil are relatively small compared to traditional markets like equities and bonds.

The changing face of market players (the rise of hedge funds, SWFs, and ETFs), along with changing perspectives on asset allocation and investment strategy, has led to the prospect of significant demand/supply imbalances.

In other words, the flow of funds can unhinge a market from its fundamentals, aka bubble.