The Dow Jones industrial average extended its rally this week, adding another 2.5 percent to finish just a whisker below its 2009 closing high, which was reached Wednesday. But as the Dow has pushed further into five-figure territory, the market’s achievement has been greeted not by champagne and celebration, but by introspection among economists and investors. Can this rally be trusted? Is it a real rebound or something else? Are we witnessing the growth of a new bubble or a zombie market propped up by outside forces?
By the math of some skeptics, the Dow’s 10,000 is only “worth” about three-quarters of that anyway, owing to the ground the U.S. dollar has lost in comparison with other currencies since the index first hit five digits. Even taking the current number at face value, though, the sheer speed of the recovery should give us pause.
While the recession’s been declared officially over, this recovery is not going to be V-shaped. It’s going to take time, given the enormity of the financial crisis that precipitated it. The Dow gained more than 53 percent from its March trough, while the S&P is up over 61 percent from its springtime low. That’s just not normal; it’s too much, too soon. Yes, the economy bounced back strongly from the 1981-82 recession, but that was because the Federal Reserve lowered interest rates by more than 10 percentage points over the course of roughly a year. That arrow’s already been shot this time around.
Take a look at other metrics unrelated to the movement of the equities market and more red flags pop up. Many of the positive or less-negative returns corporations have been delivering of late come from aggressive cost-cutting. Obviously, this tactic has a limited shelf life. Similarly, gains in productivity are a double-edged sword because they contribute to lower rehiring rates even after demand increases.
Unemployment and foreclosure rates are still rising, consumer and commercial borrowing remain restricted, and small businesses are getting hammered. Noted analyst Meredith Whitney wrote in the Wall Street Journal last month that these companies "have never had a harder time" securing financing. This latter point doesn’t seem to be factored in to the market recovery. Small businesses, although they contribute roughly half the country’s jobs, aren’t represented by the Dow Jones. Their pain isn’t reflected in the index, especially the large-cap benchmarks that so many use as a proxy for the broader economy. A look at the Russell 2000, one index that does focus on smaller companies, shows that the little guys haven’t shared in the kind of recovery their larger brethren are experiencing.
What’s holding this balloon aloft? Some attribute the rapid rise to investor euphoria at the realization that this recession hasn’t spiraled into a full-blown depression. The Federal Reserve’s continued stance of aggressively low interest rates gets partial credit. With rates so low, institutional investors that would otherwise stick to safer havens are entering the stock market just to eke out their required returns. This demand inflates prices. Low rates also play a role in that many of the stocks that have led the recent rebound are financial stocks, which benefit directly from being able to borrow money at bargain-basement rates. Just four stocks—Bank of America, Citigroup, Fannie Mae, and Freddie Mac, all of which rely on the Fed’s largesse to an outsized degree — are responsible for up to 20 percent of all trades .
Direct and indirect infusions of capital into the banking sector are another factor. The Center for Economic & Policy Research crunched some numbers and issued a report last month asserting that half of this year’s profits for banks the group dubbed “too big to fail” institutions are a direct result of government’s facilitation of lower-cost borrowing.
Some analysts also finger the burgeoning growth in high-frequency trading that got the attention of Sen. Charles Schumer of New York (and the SEC’s Mary Schapiro) last summer. High-frequency traders are speculative, as opposed to long-term, investors. They don’t need to be concerned about whether or not a company’s fundamentals back up the price. Since high-frequency trades make up 70 percent of the market by trading volume, some people believe that it has an accelerant effect on the market just by virtue of its size. And if 70 percent of the market’s volume isn’t looking at basics like profit relative to earnings and prospects for future growth, there’s going to be a yawning disconnect.
The biggest indication of all that these market gains are more pep than rally—and one that offers a sobering glimpse of how this party might end—is what’s going on with 401(k) mutual funds managed by retail investors. Usually, these fund inflows echo the market, buying into booms late and waiting too long to bail out of busts. In other words, you’d expect the modest amounts put by such funds into the U.S. equities market following the March drop to be increasing by leaps and bounds right about now. Instead, they’re moving in the other direction.
July was virtually flat, with a net $2.2 billion inflow. (That might sound like a lot, but it’s not; by comparison, taxable bond inflows were at $27.9 billion for the same time period.) August saw a net loss, and that trend has continued through September and October. It’s baffling, given that this flight was occurring exactly when the market was settling into a steady climb that should have been catnip for the 401(k) crowd.
One could make the bullish case that what’s going on here is that mutual fund inflows are just late to the rally as usual, but that’s not the case. Inflows are a glimpse into Main Street sentiment, and the fact that they’re diverging so sharply from the Wall Street party line is telling. The stock market might be climbing, but retail investors have no confidence in it. They’re worried for their jobs, their homes are under water, and they’ve pushed back their retirement dates—all of which means they’re also continuing to pare their spending and borrowing. Wall Street can coast along for a while on government generosity and companies squeezing profits out of increasingly anorexic balance sheets, but that’s not going to continue forever.