Does Economy Justify This Stock Rally?

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When the stock market gives you a gift like a 7.7% monthly return it’s almost impolite to question the justification for such a rise. Well, let’s be impolite then. The stock market, in this case the Dow, has risen sharply over the past month most likely because the economy is muddling along, improving bit by bit,  and the Federal Reserve has indicated it will do what it must in order to maintain the status quo. The September gains went a long way toward making the 3rd quarter a good one, with the Dow returning 10.4%. But is the economy’s progress–and its prospects–sufficiently good to warrant this big stock market jump?

The economic data are mixed, as evidenced by Friday mornings contrast of back-to-back monthly improvements in consumer spending–albeit weak improvements–and the disappointing ISM Survey of  manufacturers. The survey index came in at 54.4 for September, versus 56.3 in August.  Any reading over 50 says that manufacturing is expanding, but the fact that the index is declining says that there is weakness–not momentum–out there. Of greatest concern, ISM’s new orders index dropped to 51.1 from 53.1 in the prior month. New orders are the fuel for improving growth, so the fact that the measure of this is falling is not encouraging.

Goldman Sachs does a sort of shadow survey to the ISM, which it released earlier this week.  It compiles its index  by surveying its analysts  on the general activity of the companies they follow, covering new orders, sales/shipments, employment changes, materials prices and inventories. What the Goldman analysts say is that sales slowed sharply in September. This was balanced by better news on new orders, which rose briskly, and inventories which also grew, outpacing demand growth.

This growing gap between inventory accumulation and demand growth, Goldman economist David Kelley notes, “does not bode well for future strength in industrial output.”  Interestingly, the Goldman survey did pick up two encouraging trends: “Both the capital spending and employment indeces increased, suggesting companies have been more willing to invest this month.”

On balance it seems as if American CEOs see rising demand from emerging markets and stable demand here in the U.S.. More important, a large portion of profits are now coming from greatly reduced costs. According to Zacks Equity Research, which surveys analysts across many firms, the total earnings for the S&P 500 are expected to rise 41.2% in 2010 on a 4.65% rise in revenues. That’s a pretty stunning disconnect between  sales and profits, or between economic growth and U.S. corporate health. And therein lies the  partial explanation for why this market can climb while the economy slowly mends.

One more thought on this rising market: Nobody believes it. The flows into equity funds from individuals are practically nil, while billions of dollars flow from their pockets into bond funds. On the institutional investor side, a new poll of  strategists by Merrill Lynch indicates that the mood is declining–perhaps a reflection of concern about rising market indeces and flat economic stats. Merrill’s chief strategist, David Bianco, sees this doubt as an encouraging sign. “Wall Street sentiment is exhibiting similar patterns to the mid-cycle pauses of 1995 and 2003, where it took years for Wall Street strategists to believe in the bull market.”