The Stock Market's Happy Daze

Investors feel good, maybe too good.

A 25% rally in U.S. stocks in just three weeks has lightened the mood on Wall Street. But professional investors also are scratching their heads, wondering how market sentiment could have shifted so quickly.

In early March, there was much doom and gloom, and major indexes sat at their lowest levels in a dozen years. "The tone has definitely changed over the last three or four weeks," says Robert Bacarella, portfolio manager of the Monetta Mutual Funds (MONTX).

No Guarantee of Strong Recovery

Stocks have been lifted by various news items, chiefly a U.S. Treasury plan to buy up toxic assets and the occasional, small signs the economy might be slowing its slide.

On Apr. 2, stocks extended their gainson two news items: At the G-20 economic summit world leaders tripled lending by the International Monetary Fund to emerging countries. And, in Washington, the Financial Accounting Standards Board, or FASB, relaxed rules on marking down assets, which should limit losses reported by banks and other institutions.

But all this news hasn't altered a fundamental fact: The economy, both in the U.S. and worldwide, is in bad shape, and a strong recovery is hardly guaranteed. "The sum of all these small bits of news doesn't add up to the whole of a good fundamental outlook," says Chris Johnson of the Johnson Research Group.

Presidential PR is Helping

Stocks may have seen their worst levels in early March, but that doesn't mean the economy has hit bottom. "There's nothing out there yet that would really suggest we're close to a bottom in the economy," says John Merrill, chief investment officer at Tanglewood Wealth Management.

That doesn't mean the shift in investors' mood isn't significant. A public relations campaign by the Obama Administration and others has been largely successful in lifting market confidence, says Johnson, who initially doubted this rally. "The path of least resistance right now, whether right or wrong, is to the upside," he says.

Rob Lutts, founder and president of Cabot Money Management, worries about the long-term effects of loosening accounting rules. But for the short term, the FASB decision "gives [banks] a little extra cushion, which they needed."

Rule Change Could Spark Lending

And, many investors bet that what is good for the banks is good for the economy. "What the economy needs to recover is easier credit," says Uri Landesman of ING Investment Management (ING). He hopes the FASB rule change stimulates more bank lending.

More resources for the International Monetary Fund are a positive for investors looking for a revival in the world economy. Tanglewood's Merrill is investing in emerging markets and especially China. Those markets "got beat up the most last year," he says, but "their long-term attributes seem to be at least as good, if not better, than developed markets."

"It's all coming together," Bacarella says of the recent tidbits of good news. But, he warns: "The little pieces are constructive, but we still need that key confirmation." That would be real signs that the economy has stabilized.

Alcoa Kicks Off Earnings Season

An important test for the market and economic fundamentals will be the first quarter earnings season. On Apr. 7, Alcoa (AA) will be the first major company to report results from the first three months of 2009. Earnings season "is where we're going to see the proverbial rubber meeting the road," Johnson says.

Earnings are expected to be brutal, which makes sense for a quarter in which Action Economics estimates the U.S. economy shrunk 4.5%. Yet investors' expectations are already very low, and they will listen for any traces of a hopeful tone in the outlooks given by executives, Johnson says. In earnings stabilize or if executives' outlooks improve, stocks could make a further move higher, Johnson says.

But the recent market rally might be a problem for investors hoping for a positive reaction to earnings news. A month ago, with stocks looking very cheap, a few pieces of good news were enough to spark a rally. Brian Reynolds, chief market strategist at WJB Group, explains that, when stocks are in an "oversold condition, any good news is taken positively." By contrast, "now, it's a battleground," he says, between bearish and bullish investors.

Bad News is on the Way

"The market's a little overbought," Landesman says. "It's tolerance for bad news is not that high."

And bad news is certainly in the offing. Even if the U.S. economy recovers in the second half of the year, nearly every economist expects unemployment to go higher. "The economy is bad and likely to get worse," Reynolds says. Instead of a rebound, he predicts the economy could falter again in the second half of the year, followed by a recovery finally in 2010.

By contrast, if you believe the economy can bounce back soon, you're optimistic for stocks. "The market can move up from here, especially when the economy shows some signs of bottoming," Landesman says.

Reynolds says markets, driven by short-term traders, could see some violent moves in the weeks ahead—either up or down. Johnson agrees, saying, "this market could turn very, very quickly."

Too Early to Celebrate

The stock market seems to reflect the perception that the worst is over, Bacarella says. "But we still don't have a lot of conviction that things are going to get better soon," he adds.

In that environment, investors are naturally jittery. They're stuck waiting for a recovery—in earnings and the economy—that might not arrive for quarters or even years. So while the current market rebound may prompt some guarded cork-popping, don't look for a full-scale celebration on Wall Street anytime soon.

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