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QE and Real Economy Valuation Gap

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There is a meaningful and growing gap between QE market valuations and the economic reality.

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MINYANVILLE ORIGINAL Over the past four years, equity markets have more than doubled while many individual stocks now exceed their 2007 highs. Just this year the S&P 500 (INDEXSP:.INX) is up 14%. Commodities have also risen dramatically over the past four years with gold, oil, copper, and agricultural commodities leading the way.

At the same time the global economy is facing very serious and potentially dangerous challenges. Staggering developed-country debt and deficits, European recessions and banking insolvency, US fiscal cliff, worse-than-projected Chinese slowdown, rising food costs in the emerging markets, and the threat of war in the Middle East all loom large as we close out 2012 and enter 2013.

Central banks all over the world have recently committed to pumping massive liquidity into the markets in an attempt to thwart the above headwinds. The question is how long liquidity can trump the real economy.

Given the great gains already experienced in the markets as well as the serious problems we face, our estimation is that this valuation gap has almost reached its limits. Any good news (and we now consider Spain needing a bailout good news) could lift markets another 5 to 10% most likely by year-end. At that point, we think the valuation gap will have grown to a point that it cannot continue to increase.

Over time we think the real economy will demonstrate that liquidity is providing less of an economic boost than anticipated. Markets will then become very vulnerable to any bad news and are likely to have long overdue 20% correction.

Strategies

Since markets have moved in such a dramatic fashion and only 5-10% upside likely remains, we will not overplay the remaining upward move and will be very nimble if certain technical levels are breached.

The two areas likely to gain the most in the short term are financials and precious metals and that is where my firm will focus our tactical trading attention. At the same time we are building a list of short candidates in order to capitalize on the anticipated correction likely to occur early next year.
No positions in stocks mentioned.
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