The Puzzling Equity Market Rally

The recent US equity market rally continues to puzzle me. The nearly 30% rise since the S&P500 Index's most recent bottom of March 9th seems to be floating on air, given the current recessionary economic environment.

Of course, many pundits are claiming that, given a market rally, economic recovery must be around the corner. Such reasoning seems backward to me, but, that's the $64,000 question, is it not?

The Economist's April 25th edition's lead editorial, entitled "A glimmer of hope?" addresses these matters directly. The essentials of this excellent piece are distilled in this passage,

"But, welcome as it is, optimism contains two traps, one obvious, the other more subtle. The obvious trap is that confidence proves misplaced- that the glimmers of hope are misinterpreted as the beginnings of a strong recovery when all they really show is that the rate of decline is slowing. The subtler trap, particularly for politicians, is that confidence and better news create ruinous complacency. Optimism is one thing, but hubris that the world economy is returning to normal could hinder recovery and block policies to protect against a further plunge into the depths."

The remainder of the two-page editorial examines these points, and their consequences, in great and credible detail.

Personally, I do believe the first point of the passage. While current economic decline may have slowed from the past few months, I don't think it marks a turning point.

As I related to a colleague recently, several pundits have reminded us that, unlike last September, major financial institutions are not failing or being rescued each month. In that sense, the financial sector's failures effects on the economy have abated, for now.

But there is a complacency with respect to that, as well. Many government officials and financial analyst continue to cry that the nexus of our problems are financial sector health. If only risk premiums decline, and various debt spreads contract to 'normal' levels, all will be well.

Unfortunately, that's not quite true. The financial sector is a transmission device, not the originator of economic activity. In this respect, many talking heads have it wrong.

Who actually wants to borrow money right now? Where is the burgeoning demand that needs to be fueled by new debt and investment?

The bulk of the federal government's cash infusions into large US financial institutions went to simply fill holes in balance sheets created by the evaporation of equity from bad mortgage-related assets. That capital didn't, per se, add to net financial capital stocks from, say, late 2007.

Housing values are down, monthly new job losses remain high, credit card lines are being cut, new rounds of commercial real estate defaults are expected, and, as my friend B noted a few weeks ago, several major banks, including Wells Fargo, are soon to experience more residential mortgage defaults as a new wave of ARMs adjust.

I just don't see the long term sustainability of this most recent equity market rise.

From January 5th to March 9th of this year, the S&P500 fell by 27%. The recent 30% rise thus has not actually returned us to that January 5th high of 927. Close, but, thanks to the magic of percentage change, a market that rises and falls continually by the same amount is, over time, going down. For this last cycle of market tops, bottoms and new tops, a +37% gain would be required to return the S&P to it's early January peak. That's a huge gain. Over three times the average long run S&P annual return.

The Economist piece notes, further on,

"Between 1929 and 1932, the Dow Jones Industrial Average soared by more than 20% four times, only to fall back below its previous lows. Today's crisis has seen five separate rallies in which share prices rose more than 10% only to subside again."

Given today's market's greater efficiencies and liquidities, even more volatility and accentuated highs and lows than those seen in the 1930s are not surprising. We've seen two +20% S&P rallies just since November of last year.

The other major point of The Economist's editorial is food for another, later post. But, for now, I am unfortunately comforted by that magazine's concordance with my own view that this recent, fast and steep equity market rally is unlikely to last, and likely to see a rollercoaster ride back down to new lows in the months ahead.