IE 11 is not supported. For an optimal experience visit our site on another browser.

Is this stock market rally for real?

With the stock market up 25 percent from November lows, a lot of individual investors are asking: Is this rally for real?
/ Source:

For the past quarter century, many individual investors followed a fairly simple investment strategy: set aside regular savings to invest, buy a diversified basket of holdings and ride out the occasional pullbacks by staying focused on very long term returns. That conventional wisdom generally paid off.

Now, with the stock market rallying after a crushing 40 percent decline last year, that strategy seems to be making a comeback. But there are very unconventional forces at work today that may derail that method.

After last year’s heart-stopping plunge, the stock market has gained about 25 percent since it bottomed in November. That stoked confidence among some investors and financial advisers that the worst may be over and investors who bailed out last year should now go bargain hunting.

“Stocks are cheap right now. There's a lot of cash on the sidelines, and earnings are washed out,” said Rob Morgan, a market strategist for Clermont Wealth Strategies. “We've got ingredients for positive things to happen.”

But there are also signs those traditional market signals may be flashing false positives. Here are five reasons to tread carefully.

The coming economic revival
The biggest force propping up stocks now is widespread confidence that the government is moving aggressively to revive the battered economy and credit markets. That confidence rests heavily on reports that the incoming Obama administration is readying a massive package of tax cuts and government spending to pull the economy out of its tailspin. Merrill Lynch economist David Rosenberg has dubbed the market’s recent market gain a “shovel-ready rally” — one that assumes the economy will get back on track by the middle of this year.

“The market may be focused less on the patient right now and more on the cure,” he wrote this week. “This, in turn, means that the doctors better come up with something that is going to turn the economy around.”

But the positive impact of the stimulus package is far from assured. Since last spring, the government has thrown $165 billion in stimulus and rebate checks at the economy, along with $350 billion to buy up bank assets — all on top of a $1 trillion-plus pump priming by the Federal Reserve, which also has pushed short-term interest rates to near zero.

So far, the results have been mixed. Consumers used their rebate checks to save or pay down debts, not spend. Banks have used their newfound billions to bolster battered balance sheets, not lend.

With most economists looking for those measures to begin working by the second half of the year, any delay in that recovery could spell big trouble for investors, according to Joe Battipaglia, a market strategist at Stifel Nicolaus.

“Investors can get very impatient — read that as they become very nervous — when the stimulative activity doesn't take hold, where the Federal Reserve has stayed at zero for a long period of time yet the private sector is still in contraction,” he said.

Fed to the rescue
As the market waits for Congress to act on more stimulus, the Fed has been aggressively pumping money into financial markets.

Investors have also been conditioned to believe that when the Fed floods the system with money, the market responds. Perhaps the most dramatic demonstration came following the Crash of 1987. Stocks dropped 508 points, or almost 23 percent, on Oct. 19, 1987. When word spread that the Fed had opened the financial sluice gates, stocks surged the very next day.

Since it began pumping money in September, the Fed hasn’t loosened up the gears of the economy. Businesses are still cutting jobs and consumers are keeping their wallets shut. Despite committing over $1 trillion, through a maze of lending programs unprecedented in the Fed's 96-year history, economic data continue to point to a steep decline.

“It's impossible given all the government intervention to really figure out what's going to happen this year and when bottoms of markets are going to take place,” said Doug Dachille, CEO of First Principles Capital Management.

Buy and hold
The conventional wisdom of modern investing also holds that investors who hang on during market pullbacks will be rewarded eventually. Bullish advisers are also quick to point out that the biggest gains often occur early in any rally, and that it can be difficult to see them coming. Until recently, market pullbacks were relatively short-lived, which helped support the “buy and hold” philosophy adopted by many long-term investors for a generation.

But over the years, that long-range approach has been less reliable. During protracted periods of economic breakdown, like the 1930s and 1970s, short-lived market rallies were followed by devastating pullbacks — leaving buy-and-holders with negligible gains. That kind of market calls for an entirely different set of investing skills, according to Tobias Levkovich, chief U.S. equity strategist at Citigroup.

"You can get very significant rallies, but investors who stick with a buy-and-hold strategy are probably not going to be the winners,” he said. “It's people who can trade more effectively."

Cracked nest eggs
The bull market that began in 1982 was fueled in part by a dramatic shift in retirement savings after the creation of individual retirement accounts like company-sponsored 401(k) plans. Most participants who opted to make regular contributions followed the “buy and hold” strategy,  making relatively few changes to their holdings. That steady stream of cash helped the stock market produce one of its strongest 25-year gains in history. More recently, the popularity of 529 college savings plans have created a new pool of savings that flowed into stocks.

But last year's historic stock market pullback — the worst annual performance since 1931 — may have soured some of those investors to stocks for a long time.  Investors who are near retirement age have limited time to bear additional losses. Some 36 percent of Americans 45 and older say they’ve stopped putting money into a 401(k), IRA or other retirement account — up from 20 percent in October, according to a recent survey from AARP.

Younger investors who are starting to build retirement accounts may think twice before investing heavily in stocks after seeing the recent losses.

And as more baby boomers reach retirement age, they will become sellers of stocks. Many of them are saying they already lost a large portion of their retirement savings and will have to work harder to make ends meet with what they have left.

“We don't know if we will live long enough to see any recovery,” wrote one reader from Pennsylvania. “I guess the only answer to our dilemma is to die 10 years sooner than we had expected.  Or perhaps us old folks can get a job as Wal-Mart greeters.”

Are stocks really 'cheap'?
One of the most compelling arguments for putting savings into stocks today is that they are “cheap” by historical standards. Indeed, with the Standard and Poor’s 500 index marked down roughly 40 percent since it peaked in October 2007, stock prices look almost as cheap as this year’s post-holiday closeouts at the mall.

But that assumes investors will continue to value stocks roughly the same way they’ve done for the past 25 years. One of the simplest ways to judge how much a stock is worth is to look at the underlying company’s profits.

Based on one of the most widely followed measures, the ratio of stock prices to earnings for the S&P 500 stood at about 15 at the end of the third quarter, the latest available earnings. That’s near the average price-earnings ratios tracked by S&P since 1936. So the conventional wisdom argues that as the economy recovers next year and companies begin posting higher profits, stock prices should follow.

But that scenario assumes investors will continue to pay the same price for each dollar of earnings that they’ve a paid for the past 25 years. During that period, the p-e ratio for the S&P 500 has ranged between 10 and 46 (during the height of the tech bubble) and it averaged over 21 (higher than the long-term norm).

Since 1936, the stock market has traded for extended periods at a p-e ratio well below the long-term average of 15.7, however. From January 1977 until September 1982, for example, the S&P 500 never traded above 10 times earnings, and the average for that period was 8.3.

Analysts surveyed by S&P currently expect that multiple to continue to fall next year — to 12.8 times earnings. If the economy were to hit another prolonged bad patch like the 1970s, and that price multiple continues to fall, it could be some time before the stock market finds a bottom.