Here's yet another installment in a long-running series. The main thesis is that fear—with the VIX index being a good proxy for the market's level of fear, uncertainty and doubt—played a big role in the economy's collapse last year. Fear, counterparty risk, deleveraging, cash hoarding, declining money velocity, safe haven refuges: all were part of the same story. So as fear declines (shown in this chart as a rising red line) and confidence returns, the economy ought to be able to recover a lot of the ground it lost.
Some of the lost ground may not be recoverable, however, and that would be the portion attributable to misguided policy actions of the Bush administration (e.g., the Paulson/Geither bailouts), and the Obama administration (e.g., the $800 billion stimulus package, the Chrysler takeover, the trillion-dollar-deficits budget, and more recently the cap and trade bill, all of which were rammed through with the mantra "there's no time to look at the details, just vote yes"). These policy actions all share two dreadful features: they dramatically expand the scope and power of government, and they promise a significant increase in future tax burdens. And that, in turn, means that the future growth prospects of the U.S. economy have been diminished. Profits will be less than they otherwise might have been, and living standards will be less than they otherwise might have been.
But those are long-range considerations. For now, the main issue is getting the economy back on a recovery track. I think a recovery is underway, and it is being fueled by a restoration of confidence and the return of liquidity to the markets. There are still legions of skeptics out there, however, and we will undoubtedly be barraged for many months by bad news, as more companies and banks fail and as more and more underwater homewowners default on their obligations. Still, the fact that the VIX index, as well as other key and leading indicators such as swap spreads, are returning to "normal" tells me that there is still room for improvement in the economic fundamentals and in the pricing of risky assets. So I think we will see equity prices continuing to drift higher in coming months.
Full disclosure: I am long IVV (S&P 500 ETF) at the time of this writing.