Why the Stock Market Rally Isn’t Likely to Last

U.S. share prices are rising, even though the economic picture both here and in Europe is getting worse. Why is it happening and what should you do about it?

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So far in October, the Dow has risen nearly 12%, even though the global economy still looks dead in the water. The obvious question is why share prices keep rising – and whether the rally should alter your portfolio strategy. Here’s the short answer: Ignore monthly market movements and focus on strong companies with undervalued shares and businesses that will grow over the long term.

That may just sound like a restatement of conventional wisdom, but at times like these, it’s easy to forget. Nothing makes investors quite as antsy as a rising market in a lousy economy. They fear missing the quick profits that typically occur at the beginning of a recovery. But they also fear getting suckered into a double-dip: Fool me twice, shame on me!

(LIST: 12 Things We Buy in a Bad Economy)

One possible explanation for the rally is simply that investors have very short attention spans. There haven’t been any real economic disasters in the past few weeks. A more rational explanation is that recent earnings reports have been somewhat better than expected. That’s not unusual, however. Companies typically talk down their prospects so that expectations are lower than the numbers they eventually report.

Looking out further, by contrast, global economic problems seem just as bad as ever. In the U.S., GDP growth has slowed to a crawl. After peaking at 10.1% two years ago, unemployment has come down only slightly, to 9.1%. And consumer prices have risen almost 4% over the past 12 months. It’s all reminiscent of the stagflation of the 1970s.

In fact, there’s every reason to believe that global economic gridlock will get worse. The Congressional Super Committee, charged with finding ways to cut the federal deficit, seems likely to miss the Nov. 23 deadline. At the same time, while investors are hopeful that a European deal can be struck to bail out Greece, the proposed solutions are brutal and could easily fail.

Traditional responses to bad times don’t offer an easy answer today, as a recent cover story in The Economist explains: Putting money into government bonds as a safe haven in the event of a recession doesn’t protect against inflation; going into inflation hedges – from gold to oil stocks – doesn’t protect against an economic slowdown. And going into blue chips isn’t an alternative, since by some measures the overall market is still rather expensive.

In short, there’s no easy answer. But when you evaluate your strategy, remember these two things: First, you probably have a long time horizon. The market is completely unpredictable in the short run, but if you’re like most individual investors, that uncertainty won’t matter. Focus on building a portfolio of reasonably priced stocks that will grow over the long-term.

Second, your real goal is minimizing risk. Any reasonably well-chosen group of stocks will grow over time. Spend less energy trying to beat the market and more avoiding losses resulting either from buying shares that are seriously overpriced or investing in companies with shaky finances. It’s also a smart idea to diversify as broadly as you can.

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It’s true that by some measures the overall market is priced a little bit above its historical average. But there are plenty of individual stocks that look like good values. As I wrote last week, big oil stocks and some tech giants have strong balance sheets, moderate share prices and offer yields that are quite attractive in this era of minimal interest rates for savings.

Moreover, you can find individual stocks in industries such as health care, consumer products and basic industry that meet the same tests. Stocks that I like include Johnson & Johnson, Abbott Laboratories, Kimberly-Clark, Procter & Gamble, and DuPont. If you’re limited to investing in funds, consider those with a value orientation or above-average dividend yields.

So can the stock market rally really last? I don’t know, but it doesn’t seem likely. There sure could be plenty of economic turmoil between now and the next presidential election. Whatever happens, though, it won’t much change my portfolio strategy. The only real effect is that I’m keeping some extra cash in reserve to scoop up bargains if there’s ever a drastic sell-off.