Behind the Great Stock Rally of 2009

The U.S. economy is coping with alarmingly high double-digit unemployment, a widening commercial real estate bust, and over-indebted consumers. Few think the economic recovery now under way will be a spectacular one in 2010. So why has the stock market surprised skeptics by powering higher in recent weeks? One explanation being bandied about by equity strategists and portfolio managers is that the stock market may be in the midst of a momentum-driven trading phenomenon known as a "melt up" that has precious little to do with economic fundamentals.

A melt up is a rapid and mass rush by investors into an asset class after a belated realization by market players that worthwhile gains are to be had there. Part herd mentality, part self-fulfilling prophecy, this trading behavior is amplified by the age-old tendency of fund managers and retail investors to chase returns in the hopes of making up for lost time and lagging performance. The U.S. stock market is enjoying an explosive rally that has humbled plenty of bears, who have been predicting a deep correction for several months now. Instead, the Standard & Poor's 500-stock index has soared 63% since its Mar.�9 low and is up 22% for 2009.

Where's the Support? That has left plenty of money pros rethinking their market outlook. "We've spent a considerable time of late assessing the conditions for a melt up," admits Bernie Schaeffer, chief executive of Schaeffer's Investment Research. He says he is baffled at how the market's rally this year has essentially been devoid of improved investor sentiment and big inflows into domestic equity funds. While bond funds have taken in nearly $330�billion so far this year, U.S. stock funds have lost almost $28�billion. A handful of big institutional investors and hedge funds, rather than retail investors, have been responsible for the lion's share of buying this year.

In fact, overall there is far greater investor enthusiasm for asset classes other than U.S. equities. Emerging markets, which have outperformed their American counterpart, are being deluged with fresh money. The red-hot junk bond market is also attracting heavy investor interest. Even gold coins are being hoarded as the yellow metal keeps breaking records.

Mom-and-pop investors in U.S. stocks, meanwhile, are only slightly less bearish than they were in March, when the market hit a 12½-year low. Yet that could change, given the impressive performance this year in the S&P 500 and Nasdaq Composite Index (NDAQ), up about 38% in 2009. "If 2010 starts out strong as well," says Schaeffer, "the fear of missing out on stock returns could prove irresistible." Not coincidentally, January happens to be high season for personal finance introspection—with outsized attention paid to the past year's performance column and the coming year's retirement account funding.

A bigger and more pronounced money shift into stocks early next year could be also induced by diminishing returns in many segments of the bond market. There is every indication that investors are scraping the bottom of the fixed-income barrel. Three-month Treasury bills, that redoubt of ultraliquidity and safety, are yielding just 0.03%. A negative yield, where people actually pay the government to safeguard their money, could be in the offing. On the other end of the curve, the 10-year Treasury note yields 3.3%, a rate that skeptics argue does not begin to buffer holders from the real risk of inflation a few years out.

The Federal Reserve doesn't just slash short-term interest rates to help banks; it does so to make sitting on cash painful enough to force investors back into the risk-reward economy. Which might not be that difficult an undertaking if there weren't so much idle cash out there—a remnant of last year's panic and subsequent spate of bank failures and bailouts, the likes of which made "return of money" outprioritize "return on money."

Pressure to Get into the Stock Market After nearly touching $4�trillion in January, money fund assets were last clocked at $3.339 trillion, according to the Investment Company Institute. Barring another crisis, the hunt for yield will prompt more drawdowns from this sizable balance and perhaps shift more funds into stocks. "What I'm expecting is people being forced to get in," says Peter Grandich, a veteran investor newsletter editor. "The vast majority of money is managed by professionals who are gauged and measured on performance, a lot of which is judged by the quarter," he adds. "In 2008 people yelled at them for not getting them out; in 2009, people are getting yelled at for not getting in. The pressure to finally commit will be on, whether managers like it not."

Of course, melt ups—like so many trends that involve investor psychology and behavioral economics—are, by definition, almost always unpredictable. Who is to say that investors haven't been rendered so skittish by the repeated heartbreaks from U.S. stocks that they would make their bets on companies in China, Brazil, and beyond before getting reacquainted with Citigroup (C), General Electric (GE), and Microsoft (MSFT)? Or that the full-fledged return of the individual investor, should it come, to the Dow, S&P, and Nasdaq wouldn't actually be a red flag for the smart money to bail?

Indeed, the last time financial pros talked of the prospect of a melt up was in early 2007, when buyout shops were snapping up companies left and right and hedge funds were putting everything else in play. Money was cheap; risk seemed overrated. So much so, in fact, that the prevailing worry then was that investors would realize there simply wasn't enough stock to go around to accommodate the flood of buy orders that were supposed to prompt a renaissance for the American stock market. It all ended in tears, of course. Wall Street cratered and took the world economy down with it.

Few are predicting a reprise of the U.S. and global market collapse of 2008 that destroyed trillions in wealth around the world. Yet until this rally attracts a broader base of investors and is supported by robust economic fundamentals instead of short-term trading strategies, it is hard to see a multiyear bull market taking hold.

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