Third quarter, 2009: Best in 11 years

Stocks keep going up, with only minor setbacks, despite all the well-advertised problems with the global economy. The quarter just ended was the best one for the Dow Jones Industrial Average since 4th quarter 1998, and the best third quarter since 1939. For those who like numbers, the MSCI ACWI rose +17.9% during the 3 months ended September 30. The best performers were those very stocks that fell the most in 2008: financials, materials and consumer discretionary companies. This is typical of the early stages of a bull market: those stocks that are hit hardest rebound the fastest.

Why are stocks doing so well? For that matter, why are bonds on a tear as well? We all know that the economy is on the skids, the financial system is still shaky, the real estate market is moribund and unemployment is nearing post-Depression highs. Banks are failing on a weekly basis owing to continuing loan defaults, particularly residential mortgages. Everyone knows that commercial real estate loans are next. US consumers remain stretched, and instead of borrowing more against their homes, are paying down debt and cutting back, both voluntarily and in response to tight credit. Massive layoffs, and fears of being laid off, are naturally exacerbating consumer cutbacks.

Yet through it all, stock prices continue skyward. Even the pullbacks have been relatively short and mild. The deepest drop since the March bottom was about –8%; the current one has only been about –4% so far. This, again, is typical of early bull markets: the first real correction of –10% or greater doesn’t usually occur for 12 to 18 months or more. By now you know that the stock market doesn’t react to the economy; rather, it anticipates it. Thus, the sharp rise in equity prices over the past 7 months points to an improving economy, and recent data confirm this view. So a rising market at this point should be no surprise.

Many people, however, worry that stocks have come too far, too fast. After all, a +69% jump in just a few months seems overdone. Surely, we must be due for a substantial drop, even if the economy continues to recover. And if we have a “double dip” recession, then a drop must certainly be in the cards.

The problem with this logic is that all of these risks are well known. Stock prices don’t react to known information, but only to surprises. And by definition, a surprise cannot be anticipated. Thus, the only thing that should cause a major change in the direction of the market is something bad that happens out of the blue. A major war with Iran could be in this category, although even that risk is starting to be discounted by the market. Continuing loan defaults and home foreclosures, lousy corporate earnings, sluggish consumer spending and rising unemployment are widely known problems that no longer have market-moving power.

Moreover, most of the surprises over the past several months have been of the positive variety. Corporate earnings are mostly better than predicted. GDP growth worldwide is coming in higher than expected. And the status of the banking industry is no longer dire. In fact, the European Union recently completed a “stress test” of its 22 largest banks (accounting for 60% of deposits in the EU) and found that they are in surprisingly good shape. None are likely to need additional capital even if the economy does much worse than expected (and yet, many are raising additional capital anyway, and successfully at that).

The other thing to keep in mind when looking at stock prices is that using the March 9 low as an anchor can be very misleading. Yes, stocks are up hugely since then, but the global bear market that took them to those lows was more severe than any since 1721 (and worse in the US than any since 1932). At the levels of this March, stock prices were pricing in a total meltdown of the financial system that never occurred. At their present levels, they are predicting a gradual recovery from a severe recession, yet remain –31% below their highs of 2007. Just to get back to those levels, the MSCI ACWI needs to rise +45% from here. This return trip will probably take another 3 years, which means the economy won’t be back to early 2008 levels until 2013. This may seem painfully slow, but it represents an annual return of over +15% including dividends—far more than you’re likely to receive from most other investments.

Over the past week or so, people have been focusing on the lousy employment numbers and what the very slow recovery of the job market might mean to the economy. The reasoning goes that we can’t see meaningful GDP growth while unemployment continues to rise and the consumer holds back. But history shows the fallacy of this reasoning: employment is one of the last indicators to turn positive, well after GDP has started growing again and the stock market recovered. During the past 4 recessions, employment didn’t start growing again until an average of 8 months after the stock market bottomed.

But job recovery keeps taking longer, for a variety of reasons. After the 1990 recession induced by the S&L crisis, for example, unemployment didn’t peak until 16 months after the market started to rebound, by which time it was already up +40% (and this after a relatively mild –20% bear market). Job recovery this time will likely take at least that long, meaning that we’re not likely to see a peak in unemployment until next July. And by then, stocks could well be significantly higher than today.

So while the gains in all asset classes have been impressive over the past several months, most investors missed it. They opted for “safe” investments such as CD’s, US Treasuries and money market funds, happy to earn 1% or even less. On top of this, most investors that were willing to take some risk did so with bonds rather than stocks: from March through mid-September, mutual fund investors put 20 times as much into bond funds as stock funds. (In contrast, during the preceding bull market, stock mutual funds received 2.5 times more money than bond funds.) One has to wonder what stock prices will do when individual investors finally switch into the stock market, given how well it’s already done without much of their money.

So now we’re entering a new phase of the bull market. That the global economy is improving is now common knowledge (Australia raised interest rates in a surprise move today because the economy there is really heating up). This time around, the US is likely to be pulled up by other countries rather than leading the rebound. Where you invest, and what kinds of investments you choose, will become progressively more important. Just being bold and buying any beaten-down security is not likely to be so remunerative as it has been. And that’s a major reason behind the portfolio rebalancing that I’ve been doing lately, and will continue to do until I’ve positioned everyone as well as I can.

As always, somehow the world has made it through yet another financial crisis. Things should be a lot better for a while, until the next crisis, which likely will be far less severe than the one we just survived. But no amount of regulation will prevent bear markets, or financial panics, or recessions. You just can’t regulate human behavior, especially when ruled by emotion.

Maybe we should put Prozac in the drinking water instead of fluoride (just kidding).