On April 24, I updated by stock market valuation model and noted it's sensitivity to the assumed inflation rate.  It was fitting that I made that observation, because it appears that virtually 100% of the rally in the S&P 500 since the March 9 bottom can be explained by a rise in market inflation expectations.

Constant assumptions:

Inflation-adjusted 2009 Trend Earnings: $54.94
Normalized Payout Ratio: 50%
Inflation-adjusted Earnings/Dividend Growth Rate: 1.6%

March 9 Inputs:

S&P 500 Level: 680
Implied dividend yield: 4.0%
Implied real return (dividend + growth): 5.6%
Market Inflation Rate (30-year): 1.3%
Total Implied S&P 500 Return: 7.0% (rounded)

June 15 Inputs:

S&P 500 Level: 921
Implied dividend yield: 3.0%
Implied real return (dividend + growth): 4.6%
Market Inflation Rate (30-year): 2.5%
Total Implied S&P 500 Return: 7.1%

This is why the stock market, treasury yields and gold prices have all been positively correlated with each other for the past year.  The stock market hates deflation and adores mildly positive inflation.  To the extent that the Fed and Treasury seem to be successful in promoting reflation, the stock market goes up.  While the market will dislike runaway inflation, as I noted in my post from May 26, that is not currently a threat, despite what many commentators are saying.

So it appears that the market's equilibrium S&P return is 7%, not the 8% that I have been assuming based on historical return premium calculations.  So what changed to reduce the return premium?  Almost all of the drop in return expectations can be explained by the decrease in dividend taxes in the Bush tax cuts of 2003.  It appears that the stock market targets a 2% spread over the equilibrium after-tax return on 10-year corporate bonds.