I admit it: the current rally is perplexing to me. In an attempt to try and figure out what exactly is going on I'm going to present what I see as the bull and bear market arguments to see which makes the most sense.
The Bear Market
GDP growth is declining. According to the Bureau of Economic Analysis GDP growth for the last three quarters was 2.6%, 2% and 2.5%. Gross Private Domestic Investment was the primary reason for th decline. Residential investment has dropped 11.1%, 18.7% and 19.8% for the last three quarters. While nonresidential investment was positive for the first two of these three quarters, it declined 3.1% in the fourth quarter of 2006.
While personal consumption expenditures have increased, the consumer is heavily indebted. Household debt has increased from 97% of disposable income in 2000 to over 130% in 2006 (this information is from the Federal Reserve's Flow of Funds report). At some point these debt levels will constrain consumer spending, especially with a negative savings rate.
While inflation is not out-of-control, it is above the Fed's stated 1%-2% comfort range. Energy and agricultural prices are under upward price pressure which will prevent inflation from coming down. This in turn will keep the Federal Reserve on the sideline if GDP growth continues to slide.
