Questioning the Stock Market Rally and Economic Recovery

by Inya Ivkovic, MA

Markets are rallying, world benchmarks are gaining ground, investors are joyous, and economists are optimistic enough to initiate talks about recovery. Then again, it could all be the same kind of uber bear market rally that has swept the U.S. before: up 48% immediately after the 1929 crash, only to result in a spectacular plunge when investors finally realized they were nowhere near recovery, but in the middle of the Great Depression.

We all eagerly expected second-quarter earnings this year. It turned out that the golden benchmark, the S&P 500, beat analysts’ expectations by quite a margin. Approximately 77% of companies included in the index surprised pleasantly, even the state’s poor, orphaned ward, the troubled insurer American International Group. But what about revenues? Not only have earnings held their ground, but their growth rates have also actually increased, if for no other reason than all the bailout money in the financial systems. Revenues, however, couldn’t keep the pace. The concern is that higher earnings rates have been achieved mostly through deep cost-cutting, which is not organic growth, but the one-time kind of measures that cannot be easily repeated — you can only cut costs so much.

The next factor that could adversely impact the potential recovery concerns cyclical companies. When a cycle turns, for the worse or for the better, cyclicals are the first to follow suit and fall or gain disproportionately. True, we have seen recently some of the cyclicals, such as mining companies, gain unthinkable ground. This is why investors are likely betting that recovery is around the corner, because most of the cyclicals are in the resource business. But there is no real proof that recovery is here, which, if so, would also mean that resource companies will have to eventually give some, if not all, of their gains back. Typically, those that rise the fastest are usually the fastest on the way down, too.

There is one more factor to consider before starting to talk about recovery — the mountains of debt. The U.S. deficit has tipped over $1.14 trillion and the nation’s total dept has hit a staggering $11.7 trillion. Americans should shudder in fear of the day when all that money will have to be repaid. The U.S. government must start talking about an exit strategy and getting control of its own balance sheet. The time for that reckoning might be a year or two away still. But it will come one day and how and if we can live within that framework remains to be seen.

And then there are the “black swans,” or catastrophic economic events, that some economists and analysts are still talking about. One such black swan has already wreaked its havoc — the subprime disaster. At the time, most of those who packaged subprime mortgages knew they were a bad idea. But what no one could have predicted was that the greed would have been taken to a whole other level, with banks selling that garbage to themselves and keeping it on their books. Unwittingly or not, the “great unknown” can always happen, be it a result of greed and stupidity or of something outside the system, such as terrorist attacks or flu endemics.

All of these factors can put a damper on recovery, some potentially for quite a long time. Looking at the economic data and comparing them to the behavior of the market, I see a divergence of sentiment, where the latter is getting ahead of itself. I don’t think we’ll end up in a decade-long depression, as was the case after the 1929 crash. But I’m as certain as anyone can be that this trough could last years and that the road to the top of the next hill is going to be a long and winding one. In other words, I believe that talking about a recovery in early August 2009 is premature, to say the least.