03/06/2013 06:32 pm ET Updated Mar 12, 2013

Keep Your Eye on the Middle Class

Yesterday the Dow Jones Industrial Average hit its all-time high, but it didn't just reach the 14,164 mark set in October 2007, it sailed to a closing number of 14,253. The 126-point jump in the Dow yesterday follows an 8.8 percent increase thus far in 2013. Even so, the trading floor of the New York Stock Exchange was relatively subdued. Rather than an elated feeling of euphoria, the prevailing sentiment among traders could best be described as cautious due to the market's continued dependence on aggressive monetary intervention from the Fed. Despite that nagging detail, traders remain emboldened by 1) the belief that Ben Bernanke is here to stay (for now); and 2) the fact the economy continues to improve (albeit modestly). Both true, but are these factors enough to keep stocks in record territory?

The Fed's commitment to boost asset prices is not the only difference that exists between the environment today and the last time the Dow hit these levels in October, 2007. In contrast to the days preceding the start of the Great Recession, today's economic data continue to show an impotent U.S. economy, rife with out-of-control government spending and a nervous middle-income consumer. The economic recovery is still fragile, and we are not out of the woods yet. The last time the Dow reached these levels, U.S. debt held by the public as a percentage of GDP was around 36 percent; today it is 72 percent. The federal deficit for 2012 is nearly seven times the level it was in 2007. Elevated deficits are expected to continue, adding to our excessive debt and ultimately the prospect of higher tax rates for all.

With regard to the consumer, the situation has gotten much worse. Unemployment currently stands at 7.9 percent compared to 4.7 percent in October 2007. Data from the U.S. Census Bureau suggest that median household income was down over 8 percent in 2011 from 2007. (While this data has not yet been updated for 2012, we do not expect much of a jump from 2011 levels.) Although consumer debt levels have come down (mostly due to debt write-offs and a shift in debt burden to the government through fiscal stimulus and transfer payments), today's consumer is more cautious than he was the last time the Dow peaked in 2007. The latest reading for consumer confidence is 69 compared to levels in the mid- to high-90's in the fall of 2007. And finally, housing prices are currently 23 percent below the level of October 2007.

The consumer's role in the economy is vital, and confidence must pick up in order to boost that role. It is not enough for wealthier Americans to spend more. We need an economy in which the masses are both willing (confidence) and able (incomes) to spend money more aggressively. Until consumption's driving role in the economy returns, economic growth is likely to remain subdued.

Although economic growth remains sluggish, the Fed's passionate commitment to accomodating monetary policy buys a little time. The levels of Fed bond-buying cannot continue forever, but the Fed's involvement is not for nothing. The housing market continues to pick up, which could lend itself to the wealth effect of higher home prices. And stock market levels keep investors' minds at ease. Our concern, however, is that stock and home price appreciation generally benefits a relatively small percentage of well-to-do Americans. True economic vitality and better growth rates can only be achieved through more widespread prosperity, which means more job creation and better growth in incomes. These imperatives do not appear to be materializing as a result of aggressive monetary policy. Even so, Bernanke & Co. charge relentlessly ahead on their chosen course. We can only hope they know what they are doing.

Even though the stock market reached a new all-time high yesterday, stocks remain attractive relative to alternatives. Price-to-earnings ratios today are 14x forward earnings compared to 17x in October, 2007. This valuation discrepancy leaves us with some room for error. But stocks weren't all that expensive in 2007. Real estate prices were very high and a credit bubble had formed. The downfall of those two markets took most of everything else with it. However, absent sustained progress on the engine that makes the economy roar -- the middle class -- we suspect that stock market gains may be limited.