The rally in financial markets is driven primarily by liquidity provided by governments

Inquiring mind are reading Investors are betting on a vibrant recovery:

Equity and corporate-bond markets have also been boosted by quantitative easing (QE), the process whereby central banks create money to purchase (mostly government) bonds. That has helped keep the lid on Treasury-bond yields. In June the ten-year bond yielded almost 4%; it is currently around 3.5%, pretty low by historical standards even though governments are issuing record amounts of debt. The fear is that if QE stops, yields may rise sharply, driving up borrowing costs for everyone. “At some point the quantitative easing will come to an end but until it does this bull market is sponsored by [governments] and everyone should enjoy it,” Crispin Odey, a hedge-fund manager based in London, recently urged his clients.

Yet the stockmarket seems to assume a robust economic recovery. The S&P 500 index is trading on a price-earnings ratio of around 20, based on 2009 forecasts for operating earnings. A more cautious approach, using earnings reported under official accounting standards, puts the multiple at 27. Both numbers are well above the historical average. According to Smithers & Co, the American market is 37% overvalued on the best long-term measure, the cyclically-adjusted price-earnings ratio (which averages profits over ten years).

As a result, the markets look vulnerable to a setback. As strategists at UBS remarked in a recent research note: “Liquidity has been a much bigger driver of this market than fundamentals. Liquidity-driven rallies have a habit of reversing violently without warning.”

h/t The Economist