Nothing Wrong With the Stock Market

In a world of 24/7 cable news, the rally in the stock market over the last several months is often described by various self-proclaimed experts as suspect, unjustified, and unsustainable, given the broader economic environment we are in. Such a downbeat take, which is meant to raise alarm bells and the audience's anxiety level, certainly helps ensure some extra face time of those "analysts" in front of the cameras. The only trouble is that they are misguided and, most probably, wrong.

The seemingly dire assessment of the current state of the stock market and its medium-term prospects is based on a potent mix of a half-truth and lack of understanding of what is historically an essentially normal behavior of the stocks for this phase of the business cycle.

The half-truth in question is that those who are skeptical of the stock market's performance are focusing exclusively on the fact that prices have risen by approximately 40% (S&P 500) since March. This disguises the reality that March was actually the absolute bottom of a very sharp decline in the midst of a major recession and broader financial market turmoil, and that stock prices are still about 45% below their level of two years ago. In other words, yes, the stock market's rebound since the spring has been impressive, but from an extremely depressed level and has only recouped less than half of the losses it had suffered in the prior 18 months or so. Some perspective is always useful.

The other critical part that seems to be missing from the analysis of those who doubt the legitimacy of the stock market rally this year is that, historically, stock prices start rallying in the middle of a recession, with such a turning point preceding an economic recovery by roughly six to twelve months. This is only reasonable, as with most of the bad news associated with an economic downturn having already been discounted as the market takes a dive in the early phase of a recession, prices subsequently start looking ahead at the prospect that an improvement in the overall environment is not too far down the road; recessions do ultimately end.

With the prevailing view currently that the emerging economic recovery is likely to be of the moderate kind, there is little reason to believe that the stock market has incorporated a radically more optimistic scenario into its recent behavior. It is simply staging a rally in anticipation of an already steadily materializing end of a particularly dark period for both the economy and financial markets.

None of this suggests that stocks cannot experience temporary setbacks in the period ahead, as market perceptions about the tone of the economic recovery will inevitably oscillate. Markets, after all, do go up and down, while they may still be in the midst of a broader trend. But there is nothing to suggest that, against the realities of the current economic environment and its medium-term prospects, there is something fundamentally wrong with the behavior of stock prices so far this year.

Anthony Karydakis