NEW YORK (TheStreet) -- Macro and micro fundamentals are deteriorating in the U.S. and around the world. Two questions are begged: Why are stock prices represented by indices such as the S&P 500, Dow Jones Industrials and Nasdaq rising so dramatically? Is this rally sustainable?The answer to the first question is that stock prices are rising due to a confluence of extraordinarily high levels of liquidity on household and business balance sheets, combined with a simultaneous normalization of liquidity preferences. On the margin, this is driving a demand for equity investments. The answer to the second question is that the current rally is sustainable in the intermediate term and could indeed morph into a full-fledged bubble for reasons described in this article. Deteriorating Fundamentals An overwhelming plurality of economic indicators are signaling that the U.S. and global economies are slowing sharply relative to the already modest pace of growth in the first quarter of 2013. ISM and Markit PMI surveys, along with various indicators of industrial production, show that manufacturing activity in the U.S. is slowing sharply. Furthermore, indicators of consumption such as real disposable income and retail sales are showing signs of weakening. Finally, the pace of employment growth seems to have slowed notably in the months of April and May. Globally, the macroeconomic situation is even more worrisome, with a brutal recession accelerating in much of Europe, and pronounced slowdowns evident in Australia and China.
U.S. corporations are starting to show signs of these macroeconomic strains. US corporate earnings estimates for 2013 have come down dramatically in the past month, and look to be revised downwards much further once the lackluster first quarter performance is fully digested by analysts. US corporate earnings are contracting on a year over year (YoY) GAAP basis and is only growing at slightly over 2% YoY if measured on an operating EPS basis. So why are stock prices rising so dramatically? Excess Liquidity and Normalization of Liquidity Preference Below I present a chart of "systemic liquidity." This metric measures most readily available sources of liquidity for U.S. households and businesses as a percentage of total nominal income or GDP. The black trend line is an estimate of a "normalized" level of systemic liquidity, derived by linear regression.
Why are such extraordinarily high levels of systemic liquidity dangerous at this stage of the business cycle? The reason is that "liquidity preference" or the desire of households and businesses to hold liquidity is what drives the demand for liquidity, and liquidity preference behaves in a mean-reverting fashion driven largely by fluctuations in risk-aversion. As households and businesses gradually shed their "bunker mentality," they will no longer want to hold so much liquidity. In particular, they will not want to hoard so much of their net worth in liquid assets at negative real rates of interest. This implies that as households and businesses become less fearful and risk-averse, they will increasingly deploy their accumulated cash hoards towards increasingly risky investments that promise an attractive real rate of return.