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The S&P 500 earnings remain at record highs while price-to-earnings ratios remain below all cyclical lows. So, clearly, the panic selling you have experienced over the past weeks had nothing to do with the corporations’ ability to grow sales and earnings and when stock prices catch up with earnings we’re going to see stocks propelled to new highs.

A valuable indicator to a recovery in equities is the bond market. While yields remain at such low rates the market will refocus back on higher risk assets, such as equities, which carry higher dividend yields than bonds. That has almost always indicated a coming rally in equities.

The US growth question is less of a worry than the EU situation, only because the EU situation is being controlled by politicians whereas the US situation is not political (the US President is a lame economic duck and the US economy will start to recover due more to the actions of Ben Bernanke than the President). If this ‘stock market swoon’ continues past Labour Day (Sept 5) then we’ll see QE3 (for want of a better term) start to lift equities. This means printing more money and easing credit. This has never failed to work. What about inflation?” Central banks will probably start to see the light and lift their tolerance for inflation to around 4%. Nothing kills debt more than inflating it away and this may be one of the best ways to slowly solve the debt issue. It also eliminates the chance of deflation, lifts equity markets and lifts GDP growth.

Of course, the problem with the slightly higher inflation is that it doesn’t do a thing for the unemployment. However, if consumers start spending again then unemployment will slowly disappear.

Now you may be wondering what exactly is the ‘QE’ (1, 2 and possibly 3) and why would it do anything?

Basically, QE (quantitative easing) is a giant pool of money (QE2 was US $600 billion) that was deployed by the US Federal Reserve at their discretion to buy bond securities in the open market. These transactions remove bonds from the market, decreasing supply and pushing the purchase proceeds into the banking system. The QE2 practice of buying bonds forced investors (savers) and banks (lenders) to seek higher risk options that offered a more reasonable return. Lenders across a broad spectrum sought higher risk borrowers and this lending pushes capital into the economy. Recipients of this cheap capital hypothetically invest in new business ventures that historically create new employment opportunities. That’s the theory anyway.

Next Friday – August 26 (this article was written Aug 24), Ben Bernanke will give his Jackson Hole, Wyoming speech, this will be the same speech he gave last year when he launched QE2 and immediately started the stock market rally that fizzled in July as the European debt crisis loomed larger. The question on everyone’s lips is, will he give the markets a boost and start up QE3? Maybe, maybe not. He will talk about many positive things that are current such as the slowdown is temporary and that signs of the economy like auto sales, corporate profits, aircaraft order and improving rental sales, are all strengthening. However, none of that will really inspire the markets.

If he does introduce QE3 there will be a rally of biblical proportions. But don’t hold your breath. Whatever happens on Friday, it will be positive in some way for the market. What is really needed though is for politicians in Washington and Brussells to restore confidence. That will require policies that will see growth restored. The underlying strength is there. It just needs consumer confidence to get going.

This is a ‘Crisis of Confidence’. Restore confidence and the chaos will simply fade away.

Bill Gross – CEO of Pimco, the world’s largest Bond Fund Managers thinks that the US may fall into recession, but only a very shallow one although he did admit that it could be avoided by a further stimulus. He also admitted he would not be investing in Bonds or Gold but rather, recommending stocks which carry a dividend. A bond fund manager recommending equities? Now you know you are close to the bottom.

Thanks to Lance Spicer – Trident Confidential – for his input.