Is the Stock Market Off to the Races?

Some things aren't always as advertised. The 2009 Chicago Cubs, my front wheel drive GMC Acadia, most blind dates, and The English Patient are a few things that come to mind in that respect.

Another "thing" that stands out for us is the stock market rally since mid-July.

Entering the week beginning August 31, the S&P 500 had gained 17% since its close on July 10. It was an astounding move for a variety of reasons, the most prominent of which was that it was built on some shaky foundation.

Specifically, it wasn't a rally built on unequivocally good news. Rather, it was forged on news that was unequivocally less bad. This important distinction was evident on two fronts.

The first front was the earnings reporting front. The second front was the economic data front.

Calling a Spade a Spade

The second quarter earnings reporting period is widely regarded as having been very good. That makes sense considering 73% of the S&P 500 companies that reported earnings exceeded analyst expectations, according to Thomson Reuters. That matches the highest rate of positive earnings surprises since the first quarter 2004.

For all of that "good" news, earnings for the S&P 500 were still down 27.3% year-over-year.

All that mattered to the market, though, was that earnings weren't as bad as expected. On July 1 the second quarter earnings growth rate was estimated to be down 35.5%.

So, label the reporting period as being less bad, better than feared, or some other caustic expression, but don't call it good. Calling it truly good is like calling someone a truly good employee for missing work only one day a week since, after all, they do show up reliably the other 80% of the time. Similarly, it is a stretch to call the employment data good in an absolute sense.

In August, 216,000 positions were cut from nonfarm payrolls. That was an improvement from the 276,000 positions lost in July, but it is still a huge loss 20 months into a recession.

The market has also seemingly found some solace in the idea that the 4-week moving average for initial jobless claims has steadied in the area of 565,000, almost oblivious to the fact that it is still well above the peak seen in prior recessions.

The labor market isn't truly improving. It is truly getting less bad.

This is admittedly a better alternative than deteriorating at the rate we saw earlier in the year, yet the market wants to mistake the slower rate of deterioration for an actual improvement in job growth. That's like rationalizing a $10,000 loss in your investment account as a true improvement knowing you lost $20,000 in the prior month.

An Uncomfortable Transition

These "good news" denouncements can go on and on. We won't belabor the point. In fact, we'll concede the point that the rally since mid-July hasn't been entirely baseless.

The compendium of earnings and economic data have revealed that things look better today than they did six months ago. The stock market should have rebounded.

The uncomfortable transition for us is that the market moved expeditiously from rebounding on a relief trade that the worst scenario wasn't going to materialize to rallying on a speculative trade that has presumed things are on the cusp of being back to normal from here on out.

What It All Means

There are some obvious cross currents that suggest the stock rally since mid-July isn't all it is cracked up to be. At the least, these cross currents suggest there isn't as much faith in the robust recovery view that the stock market would have one believe there is.

That's not to say the stock market is wrong. It is a leading indicator and it will eventually be proven right; however, take note that it has jumped the gun before and has been forced to return to the starting line.

Since earnings and economic comparisons are going to be very easy in the next few quarters, the stock market could very well have more room to run.

The pace at which it runs, though, should be slowed by headwinds that include weak consumer spending, reduced business investment, higher taxes, higher interest rates, deterioration in the commercial real estate market, and a frustratingly slow recovery in residential housing.

The next 50% move up in the market isn't going to be as easy as the last 50%.

If you're not aiming to be more cautious right now, you should at least be less speculative. The easy money has been made and the time is now to be favoring high quality companies over high beta stocks.