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Looming deflationary trend takes sparkle out of stock rally

Stocks typically rise in December, so the market surge so far this month should come as no surprise. The average U.S. stock in the Value Line Arithmetic Index is at a record high - and not just a new high for the year, but a high that breaks the old peak set in the fall of 2007.

Sentiment about the outlook for the S&P 500 is wildly bullish as measured by both the American Association of Individual Investors and the Investors Intelligence surveys.

The latest Shiller price-to-earnings ratio - which measures stock prices in relation to average earnings over the past decade - jumped to 22.7 in December from 21.9 in November and 21.4 in October. This key ratio hasn't been this high since May 2008. The only problem? The market went down 45 per cent from there. According to this metric, the U.S. stock market is overvalued by nearly 40 per cent. Yikes! And the typical Wall Street strategist thinks this market is cheap.

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Even according to my models, the median fair-value for the S&P 500 is 1,120 (with a range of 1,000 to 1,200), suggesting the market is overvalued by more than 10 per cent.

All I can say is that a lot of strange things are happening on the U.S. pricing front that do not agree with the prevailing story of vibrant domestic demand. Prices in many areas seem to be deflating, not rising as you might expect on the back of a recovering economy.

Some examples:

Producer prices for boxes and containers are going down, not up. Maybe FedEx is bullish on its outlook, but if the outlook is so bright you have to wonder why it is that prices for paper boxes and containers fell 0.4 per cent in November after dropping 0.7 per cent in October. This is the steepest falloff for this time of the year in 12 years. Go figure.

This is Christmas time, following on the heels of Hanukkah time. So what is it with toy prices? They slid 1.7 per cent in November ― the second monthly decline in a row.

And what about the price of gift wrapping paper as measured in the personal-care segment of the consumer price index? It deflated at a 2.8 per cent annual rate over the past three months, the softest November reading in seven years. Then again, if you're not buying any toys to stick under the tree, then there's no need for wrapping paper, is there?

Don't forget flowers. Prices are down at a 1.5 per cent annual rate over the past three months. We haven't seen a November performance like this since 1999 when all we were buying ahead of Y2K were flashlights and bottled water.

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Turkey prices sank 2.5 per cent in November, the most important gobble time of the year, and the trend is flat for the past three months. This is amazing.

The prices of sweets sank 1.4 per cent in November, the steepest decline on record. No demand for chocolate-covered reindeers this year?

Wine prices fell 0.4 per cent in November. They hardly ever decline during this time of the year ― and are down in three of the past four months. This hasn't happened in over two decades. Then again, if the turkey price is going down, then complements like sauvignon blanc should be doing likewise, n'est-ce pas?

Not only wine, but liquor prices declined 0.8 per cent in the last two months, despite the fact that this is the most lubricating time of the year. (Come to think of it, I thought I did see someone buy a 15-year Balvenie for under $70 at the liquor store last week.)

To be fair, not everything is deflating for the retail sector. The areas that seem to have at least a modicum of pricing power so far in this holiday shopping season are apparel, sporting goods and jewellery. (That Tiffany box never does go out of fashion, does it?)

Still, those few bright spots aren't enough to make the big picture shine. By all means, enjoy this stock market rally. Just remember that behind it looms a deflationary trend that holds worrisome implications for corporate profits and stock prices in 2011.

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