You know we're in a bull market when....

You know we're in a bull market when....

General Motors, once the world’s largest corporation, files for bankruptcy protection, yet global markets rise 2.5%. That’s exactly what happened yesterday. At the same time, GM was kicked out of the Dow Jones Industrial Average after an 83-year stay, replaced by the much younger Cisco Systems. Perhaps even more a sign of the times, Citigroup is also getting the boot, to be replaced by Travelers Cos., its former subsidiary. (How’s that for poetic justice?)

That stocks rose strongly on such news continues to suggest that investors are looking forward rather than back. The demise of once mighty GM is being taken as a sign of progress, as old industries mature and downsize, while newer ones (as embodied by network router maker Cisco) continue to blossom. “Creative destruction” is necessary for economic progress, and it tends to accelerate during times of economic turmoil.

So in the midst of the worst recession since 1982, and perhaps since 1932, stocks continue to rally. Even after the strongest March and April in memory, stocks maintained their upward march in May, with the MSCI ACWI (All-Country World Index) adding another +10.0%. Stocks’ rise from their March bottom has been nothing short of impressive: the MSCI ACWI has surged +45.8% in the 59 trading days from March 9 through yesterday, and it’s actually up +9.5% for the year. Quite a turnaround from being down -24.9% year to date on March 9!

The skeptics abound, and that is good for stocks. Many investors still think the worst is ahead of us, and are waiting for this rally to fizzle and take stocks down a lot before committing their money. They are likely to have a very long wait. Even many of those who believe we’ve seen the lows for this cycle (as I do; in fact, I believe we’ve seen the lows for this century!) don’t expect stocks to rise much from here. They’ve got plenty of good reasons, too, from the slowing economy and the fragile financial system to the overleveraged consumer and surging unemployment. Many of their arguments are sound, yet stocks just keep going up. What gives?

I think that the current surge in stock prices comes from the realization that the Armageddon scenario, in which the world financial system melts down and we enter Great Depression II, is now off the table. 2009 is likely to be characterized by “just” a very severe recession and credit crunch, but nothing of the magnitude of the 1930’s or what many were imagining just a couple of months ago. And in that context, the current rapid rise in the stock market makes sense.

We’ve come down so far from the highs of 2007 that they now seem like meaningless numbers: investors have “anchored” to the recent lows rather than the more remote highs. In fact, just to bring stock prices back to where they were before the collapse of Lehman Bros. and AIG, before the Armageddon scenario first started to be priced into stocks, the MSCI ACWI would need to rise another +29% from here. At that level, stocks would again be pricing a severe recession, which is what we’re experiencing today.

So absent any new and unexpected economic shocks, it looks to me that stocks could rise another 30% or so before being fully priced. No real improvement in the economy or financial system is necessary; just the gradual adjustment of investors expectations to the current reality. Once we make it back to that level (perhaps by the end of this year), further progress will depend on the economy actually improving. Most agree that this will happen next year, and the pace of improvement will help determine the rate at which stocks continue to rise.

The biggest risk to a persistently rising stock market over the next year or so is a “double dip” recession, in which the economy improves for a few months but then starts to contract again. This has happened before and it could happen again. While such an an occurrence would almost certainly cause stocks to fall, history suggests that they will remain well above their recession lows (as they did in 1933, for example.)

I’m not expecting the double-dip scenario, but one must be prepared just in case. Such preparation does NOT mean getting out of stocks now, because that risks missing what could be a roaring bull market. Rather, it means being watchful and doing one’s best to spot a double dip early. But most important, it means not panicking should one occur and abandoning stocks just before the best part of the bull market. Those who did so in 1933 missed out on four of the best years in stock market history, and a real return of +436% over that period. I’m sure they felt pretty stupid in retrospect!

Let’s be smart and realize we can’t predict the future. But we can learn from the past, both recent and more distant. I’ve certainly learned a lot recently, and have adapted my investment style in response. Not huge changes, but incremental ones, because successful investing is an endurance contest, not a sprint.