Is This Stock Market Rally for Real?

Despite all the problems facing the global economy, the average U.S. stock has doubled from its 2009 lows. So this seems like the time to ask whether share prices have run up too far, too fast.

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REUTERS/Shannon Stapleton

Last week, the Dow reached the 13,000 mark for the first time since 2008, despite the daunting problems facing the global economy. This is suggestive of the old Wall Street saying that the stock market climbs a wall of worry. Investors tend to hold cash during economically uncertain times. And so, when their worst fears fail to materialize, they’re in a position to invest. By contrast, when investors are most confident, their money is, for the most part, already invested. As a result, the best rallies often occur when investors go from being very worried to somewhat less worried.

There’s just one catch: It’s not hard for investors to slip back to very worried pretty quickly. If the economy fails to keep improving, today’s rally could easily sputter out. Given that the economy seems to have picked up recently and that average share prices have doubled from their 2009 lows, it makes sense to consider whether investors might have become overly optimistic. Here’s a look at what might go wrong that would be serious enough to knock stocks down again:

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Oil and gas prices could keep rising. Fears of conflict with Iran are only one reason that the price of oil has gone up more than 30% since October. America and much of Europe may still be facing slow growth but demand for oil is rising in other parts of the world, particularly in Asia. At the same time, oil inventories are lower than normal and some smaller producers – such as Sudan, Syria and Yemen – have been disrupted by internal conflict. As a result, gasoline prices have reached a record for this time of year, resulting not only from high oil prices but also from reduced refining capacity. Indeed, Bloomberg reports that 5% of U.S. refining capacity has been shuttered in the past three months.

The Eurozone could break up. The recent deal to forestall a Greek default has greatly relieved international investors. But nothing has really changed. The austerity forced on Greece is reducing the country’s ability to pay its debts even faster than the debts are being cut. The result is a deftly managed decline rather than a spectacular collapse. But it remains highly likely that Greece will eventually default. That would rattle confidence in other overindebted economies, such as Italy, Spain and Portugal. The underlying problem is that Southern Europe has fallen far behind Northern Europe in terms of productivity. And there is no easy way to compensate for that gap as long as both halves of the continent are locked together in the same currency. In addition, German public opinion is shifting against paying for future bailouts, and that makes a real solution to the Eurozone crisis less and less likely.

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There could be a global recession. Last November, the European Commission was predicting slight growth in 2012, but after concluding the Greek deal, the Commission acknowledged that Europe would suffer a mild recession. At the same time, some forecasters are predicting a recession in the U.S. These downbeat forecasts don’t assume any surprise shocks, such as a spike in the price of oil or a currency collapse. Should such a thing happen, any recession would be far worse. Stock prices normally decline three to six months before a recession begins, which means that the Dow could be peaking right about now.

Politics could force a negative change in economic policy. Domestic economic news has been encouraging recently, most notably fourth-quarter real GDP growth at a 2.8% annual rate followed by January’s decline in unemployment to 8.3%. Both these statistics, however, could be overly rosy. Fourth-quarter growth was based on an inflation adjustment of only 0.4%, while the previous three quarters had been adjusted for inflation of at least 2.5%. Using that higher inflation rate, fourth-quarter real growth would almost disappear. Simultaneously, the latest Gallup poll suggests that unemployment has recently risen to its highest level in several months.

Even if the economic trends are as positive as the statistics indicate, the approaching election could force the administration to discuss changes in policy that would be negative for share prices: plans to reduce the deficit would include either cuts in government spending or higher taxes or both. An increase in the tax on dividends would hit precisely the stocks that have been the most reliable over the past few years. Any reduction in the Federal Reserve’s expansive monetary policy, or signs of incipient inflation, could push up interest rates, which would hurt stocks as well as bonds. Finally, when an agreement on the debt ceiling was reached late last year, it was intended to carry through until after the election. But because of the rapid rate of government spending, the debt ceiling could be reached again before year end.

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After the recent rally, stocks are priced for uninterrupted good news. My own portfolio is somewhat defensive with conservative stocks paying an average yield of more than 3.5% and the equivalent of about 15% in cash, so that I have money to buy several stocks I would like to own if their prices pull back. Of course, nothing may go wrong. But there is now so much potential for disappointment that some skepticism seems in order.