I was just as happy as anyone who owns stocks to see the Dow close over 9,000 yesterday. But the question that remains unanswered is why exactly did stocks rally? There are four reasons commonly offered to explain the recent rise in stocks: their prices were cheap relative to earnings, the economy is getting worse more slowly, second quarter earnings are better than expected, and investors are focusing on the economic recovery. I don’t think any of these explanations hold water.
One explanation that might make sense is that cash is scrambling into stocks — due to both short covering and huge cash balances afraid of being left behind. Short sellers bet that a stock will fall by borrowing shares from a broker and selling them at what they think will be a high price. If their bet is right, they can repay the stock loan by buying shares back in the open market at a lower price.
However, the cost of being wrong about a short bet is high. If the stock goes up, the broker demands immediate repayment, which forces the short seller to buy in a panic in order to limit the broker’s loss. Unfortunately, I don’t know how to measure how much of the recent rally is attributable to short covering.
As far as cash being on the sidelines, however, there is ample evidence of its presence there. More specifically, the amount of cash sitting in money market funds is 85 percent more than the amount that was there at the end of the last bear market in 2001. In particular, $3.7 trillion is sitting as cash in money-market funds, earning interest of less than one percent.
That’s $2 trillion more of investors’ portfolios in cash than at the worst stage of the last bear market in 2000 and 2001. It is unclear how much of this money is flowing into stocks, but it is conceivable that Dow 9,000 will make people want to get in.
So why are the four other “explanations” flimsy?
Stocks are not cheap relative to earnings. The average S&P 500 stock is now trading at 17 times earnings, up from 13.5 in April. This is a high level relative to the historical average of 15. With so many companies losing money or experiencing a decline in earnings, it is difficult to defend that idea that they deserve to trade at a premium to historical averages.
The economy is getting worse more slowly — but some key economic elements are getting worse more rapidly. First, some support for the getting worse more slowly argument: initial jobless claims are up but at a slower pace than before — 657,000 in March, 630,000 in April, 612,000 in June, and 546,000 per week in July. But bad loans are spiking. For example, at Bank of America (BAC), total nonperforming assets nearly tripled to 3.31 percent at the end of June 2009 from 1.13 percent in the prior year.
Second quarter earnings are better than expected. This may actually be true as the expectations are for massive declines in earnings, and the better performances usually mean lower declines than expected. But if you believe that investors buy earnings growth, then the basis for buying that growth is flimsy. Specifically, analysts were expecting second-quarter earnings for the S&P 500 to fall 35.6 percent, and so far they have only dropped 30.8 percent. Also, there’s no doubt that some of that cushioning of the earnings decline came from cost cutting by firing people.
Investors are focusing on the economic recovery — but what recovery? With 6.5 million out of work and companies seeking to beat earnings expectations by cutting more people, it is difficult to imagine economic growth in an economy that depends on consumer spending for 70 percent of GDP growth. Nevertheless, Deutsche Bank — which has an economic incentive to move people into stocks — sees eight of 11 economic indicators it tracks looking positive.
As I’ve said, to understand what moves stocks would require real-time disclosure of why big market players are buying and selling stocks. In the absence of that data, we are clueless to explain why stocks move and where they’re headed.
Nevertheless, the most plausible explanation for why the market is going up is the fear of being left behind or of taking a big loss on a short position by people who control trillions in cash.
Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College. His eighth book is You Can’t Order Change: Lessons from Jim McNerney’s Turnaround at Boeing. He has no financial interest in the securities mentioned.