I am thrilled by the recent stock market rally.  The Dow is up an impressive 28.6% since March 9th and is now down only 40.5% from its October 2007 high.  We are only 68.2% away from a new record.  Let the good times roll!

I sincerely hope that the stock market continues to climb.  My parents benefit materially from such gains and I postulate that the job market (at least the finance and asset management segments) may benefit from further stability and price appreciation.

Why is the Stock Market Rising?

The most important question in reference to the rally remains why is the stock market rising? 

The equity markets react to a variety of stimuli.  The stock market aggregates a large number of perspectives and attempts to predict the future of the economy.  But the market is also subject to forces which are distinct from the economic fundamentals which dictate the value of companies.

Stimulus Spending

A host of politicians, policy makers, economists and media sources are presently arguing that the economy is recovering.  This perspective is based primarily on the belief that Stimulus Spending will produce the beneficial effect professed to justify its implementation. 

The existence of a large and quantifiable plan to improve the economy in the future provides fodder for optimistic investors, regardless of current conditions or trends.

Volatility = Risk

In the institutional asset management world volatility is the functional equivalent of risk.  All else being equal, the riskier an asset is the less it is worth.  (derivatives excluded)

The latter half of 2008 and early 2009 were a period of record, sustained volatility.  This partially explains why stocks dropped so quickly and dramatically.  Volatility, uncertainty and fear were driving the market, and the perception of risk reduced the value of equities as an asset class. 

U.S. Treasuries on the other hand saw their yields drop to zero as people were so concerned about risk they were willing to lend money for no return other than the assurance their capital would be returned.

There has not been a major shock to the global economy or financial system in the past several months.  The lack of a destabilizing event has created the impression that stability has returned.  This period of relative calm has reduced the risk premium and increased the corresponding perceived value of stocks.  
 
Institutional Investors are Lemmings

Regardless of the future of the stock market or the unique perspective of an individual asset manager, there is extraordinary pressure on institutional investors to be exposed to a stock market that is rising.  Any equity investor who has not been fully invested since March 9th is now trailing the performance of the Dow and other asset managers for that timeframe. 

The longer such an investor stays out of the rising market, the farther behind the fund’s performance falls and the greater the pressure to increase equity exposure.  This reality is causing a steady and increasing flow of capital to migrate back into the stock market.

I find this phenomenon to be fascinating.  An individual asset manager may believe that the stock market is overvalued, the economy is cratering and that the DOW will be at 5,000 two years from now.  And he may be right.  Given such an understanding, the correct course of action would be to avoid risk, preserve capital and make investments that benefit from a falling market. 

But in the interim that investor’s performance lags the broader index and the pressure builds.  The idiosyncrasies of modern asset management dictate that most institutions follow the herd.  It doesn’t matter that your understanding of the future is right if you lose your job or your investors before that vision comes to fruition. 

The Stock Market’s Performance as a Bullish Indicator for the Stock Market

The majority of people draw confidence from the historical performance of asset prices. 

Consider the Housing Bubble.  Prices nationwide had not fallen in 70 years so a house was a riskless asset.  Prices had risen rapidly and consistently since 1997 so buying a house at any price was an excellent investment.

The same holds true for the stock market.  Individuals and investors draw confidence about the future of the economy and the stock market from its recent performance.  In February some people were panicked based on the stock market crash and today those same people are hopeful.

This circular logic is ridiculous.  But it will not stop investors made comfortable by recent price appreciation, which they missed, from returning money to the stock market regardless of merit.  

Dismal Reality

No credible person has ever argued that the correlation between the stock market and the fundamentals of economic activity was exact.  Just as the stock market stayed buoyant through 2007, despite two years of data that the Housing Bubble was collapsing, the markets are rising today in defiance of eroding economic fundamentals.  
 
But over the long-term the stock market tends to catch up with the realities of the economy.  I do not hazard a guess as to what is the correct value for the stock market today.  But I am able to evaluate current economic trends and generate an understanding of what the economy will look like a year from now.

Fundamental Analysis

In the four months since the stock market bottomed out has the economy gotten better or worse?  Six to twelve months from now is the economy likely to be in better shape or worse?

• Unemployment has continued to rise.  According to last week’s CBO projection, unemployment will increase for the next 16 months to a peak above 10% from a current value of approximately 9%.
• Housing prices have continued to fall with the first quarter setting a new record for the nation’s most rapid decline.  While many predict that the pace of price declines will moderate, prices will certainly continue to decline through this year and next.  A few sources are predicting price stability in 2010, but those sources have little credibility having misinterpreted the Housing Recession to date. 
• Foreclosures continue to increase and establish new records.  The pace of defaults will continue for the foreseeable future with 12% of all mortgage holders behind on their payments, 1 in 3 underwater, and unemployment rising.  2010 will set a new record for foreclosures.
• Other factors likely to worsen over the next six to twelve months:
• Global trade has and will continue to contract 
• The commercial real estate collapse has only begun. 
• The consumer debt crisis will intensify
• Interest rates have started to rise as unsustainable debt accumulation will continue to increase borrowing costs  

 Conclusion

The recent stock market rally has nothing to do with improving fundamentals or sustainable economic stability.  Its current value is only justifiable to the extent that the market was oversold in March and has recovered from a panicked capital flight.  Regardless, it is difficult to believe that the current valuation will be sustained as much of the economy steadily deteriorates over the next year.  Once the hope for a Stimulus-led recovery fades, the economy’s weakened state will return to focus, and the risk premium will again reflect reality.