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Optimism about a recovery starting to fizzle

Some investors and market watchers say the stock market may have overestimated the prospects for an economic rebound — and share prices could be due for a big pullback.

What happened to all the optimism?

Less than a week ago, many people were celebrating the beginning of the recovery. The Federal Reserve itself claimed the economy is “leveling out.”

Now some investors and market watchers say the stock market may have overestimated the prospects for an economic rebound — and share prices could be due for a bigger pullback after a 50 percent surge since March.

"The market has gotten way ahead of the reality on the ground,” Pimco's Mohamed El-Erian, co-chief executive officer of the largest bond fund manager in the world, told CNBC Friday. "We are yet to see a durable and sustainable recovery, but the market has gotten ahead of the process by pricing that in."

On Monday, some investors echoed those second thoughts, sending stocks 2 percent lower and stalling a rally that had pushed the market up 15 percent since mid-July.

The initial exuberance followed economic data over the past few weeks showing that one of the worst recessions since World War II many be ending. Job losses slowed in July. Many forecasters believe the U.S. Gross Domestic Product will likely turn positive again in the third quarter after steep declines since the recession began in Dec. 2007.

The relentless retreat of housing prices seems to be slowing. And massive infusions of government cash — the $787 billion economic stimulus package, the $700 billion bank bailout and the Federal Reserve's $1 trillion intervention in the financial markets — seem to be having the desired effect.

The government-led effort may have stopped the bleeding. There is less evidence that the second phase of recovery is taking hold, however, said Barbara Marcin, who manages the Gabelli Blue Chip Value fund.

"That (government intervention) is supposed to jump start the real economy and start consumer spending,” she said. “In previous recessions with stimulus programs, autos and housing get under way, they start to create a little confidence, banks start to lend more, consumers start to borrow more and the second part takes off. I don't think there are any signs of that. I think we're six or nine months ahead of ourselves.”

Stock investors also have been encouraged by the latest round of quarterly corporate earnings reports, which came in stronger than expected. But a closer examination shows much of that profit came from cost cutting — laying off workers — and then selling off inventories to meet limited demand.

That’s not a formula for long-term growth. For that, consumers need to get back to levels of spending not seen since the economy began contracting 18 months ago. But consumer confidence readings fell sharply in July, indicating a pick-up in demand isn’t imminent.

For now, consumers face a number of burdens that may crimp their spending for some time.

The biggest drag on spending is the high level of unemployment. Almost 7 million workers have lost their paychecks since the recession began. Unemployment benefits and stimulus tax cuts have helped, but confidence in the job market remains weak. That’s one reason the savings rate has jumped. Households are saving for a rainy day and trying to restore wealth lost to the housing market collapsed.

Housing wealth still is evaporating as the pace of foreclosures rises and those homes are sold into a distressed market. Once the housing market stabilizes, those unsold homes will likely continue to weigh on house prices.

"You’ll be left with probably six million excess homes, the way we calculate it," said Jason Trennert, chief investment strategist of Strategas Research Partners. "And with 1 percent household growth a year, it takes a while to get through that."

Meanwhile, falling prices have left something like a third of homeowners with mortgages “underwater" — or owing more than their house is worth. One Wall Street firm recently estimated that number could rise to half of all homeowners by 2011.

"Home prices expanded by 170 percent between 1995 and 2005," said Marcin. "That’s exactly how much debt expanded. Everybody still has that debt, but their home price is down. I think that's going to weigh on consumers for a while."

With high levels of debt outstanding, it’s going to be tough for consumers to borrow more to bring spending back to pre-recession levels, say analysts.

"I’m of the view that the credit cycle will never be the same in our lifetime," said Trennert. "You're actually going to have to have money to borrow money. You’re actually going to have to have assets and a job and all the rest of it. That’s a generational change."

After an infusion of hundreds of billions of bailout funds, the nation’s big banks are still repairing the damage from an historic lending spree that left big holes in their balance sheets. Smaller banks are also showing signs of stress. On Friday, federal regulators shut down Colonial BancGroup, a major real estate lender that collapsed amid ongoing trouble in the commercial real estate market. With about $25 billion in assets, it was the biggest U.S. bank to fail this year,

And the source of much of the lending during the past decade — the so-called “shadow” banking system of securitized lending — remains sluggish despite the Fed’s efforts to revive it. On Monday, Fed officials said they were extending the Term Asset-Backed Securities Loan Facility for another six months because the markets for these securities backed by consumer and business loans “are still impaired and seem likely to remain so for some time."

"One of our big problems right now is not only are the big banks not in great shape, but also the overall financial system and the shadow banking system is also not in great shape," said Frederic Mishkin, Columbia University economics professor and former Fed governor. “That’s one of the reasons why we have a huge drag on the economy that’s going to make this recovery and this bounce back not the normal one we typically see after we've had severe contraction." 

All of which will likely continue to crimp business hiring and investment, putting pressure on corporate profits. Until consumer and business demand picks up — replacing the government’s stimulus demand — stock market gains will likely remain weak, said Trennert. But that doesn’t mean there won’t be individual companies and industries that buck the trend.

"Returns will be less," said Trennert. "But I truly believe good active managers have a much greater role to play because you don't have a rising tide lifting all boats. Stock picking is going to make a much bigger difference."