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The Stock Market's Fragile Rally

The stock market is proving again that its movements don't always make sense. On July 23 the Dow Jones industrial average bounced back above 9,000 for the first time since January—on a day when Wall Street learned that more than 500,000 Americans filed for jobless claims last week.

Meanwhile, earnings reports show corporate profits falling by almost one-third, yet the stock market sits at its highest point this year. In the first two weeks of earnings season, in fact, the broad S&P 500 is up 11%.

That's not to say market observers can't cite explanations for the recent stock rally.

Second-quarter earnings are bad, but they're beating very low expectations. Before earnings season began, Thomson Reuters (TRI) said analysts were expecting second-quarter earnings for the S&P 500 to fall 35.6%. Now, updated based on early results, earnings should drop a mere 30.8%.

Companies such as 3M (MMM), which reported second-quarter results on July 23, are seeing profits and sales fall compared with last year. But they're beating first-quarter results, and they are raising estimates for profits in the second half of the year.

Americans continue to lose their jobs at an alarming rate. But the pace is slowing. Initial jobless claims have averaged 546,000 per week in July, but that's down from 612,000 in June, 630,000 in April, and 657,000 in March, Action Economics notes.

The Nasdaq Is Jumping Still, there may be something other than fundamentals, such as earnings and the economy, that is driving the recent market rally. On July 23, the market's upward momentum was especially strong, with all three major indexes jumping more than 2%. The Dow broke through a psychological barrier of 9,000, closing at 9,069. The S&P 500 is now up 8.1% for 2009. Closing at 976.29, the S&P is tantalizingly close to its own round number of 1,000.

The Nasdaq composite index is up a whopping 25.1% this year, speaking to the relative popularity of tech stocks in 2009. The Nasdaq, at 1,973.60—just 1.3% from the 2,000 mark—has made up all of its losses since Oct. 2, 2008. The tech-heavy index—and the stock market as a whole—could be hurt by weak results from Microsoft (MSFT) and Amazon (AMZN) after the market close on July 23.

But bad news might not be enough to derail the rally entirely. That's because some of the key drivers of the market lately are psychological and technical, not fundamental. "Right now we are in a momentum-driven rally," says Prudential Financial (PRU) market strategist Quincy Krosby.

There is "panic buying," with many investors jumping into the market as it moves higher because they're afraid of being left behind, says Michael Church of Addison Capital Management.

Although the economy remains weak, Church wonders if the stock rally could become a self-fulfilling prophecy. Higher stock prices could revive the confidence of wealthy consumers, helping the economy get back on its feet. Those buying equities may be starting to include not just traders but pension funds and other institutions with major buying power. Compared with their usual allocations, institutional investors have been underexposed to equities all year, says John Merrill of Tanglewood Wealth Management. "You can only do that for so long."

As the fundamental outlook stabilizes and stocks move higher, these investors are rethinking their allocations. And "when everybody tries to get into the market at the same time, it pushes equities higher," Merrill says.

Trillions of Dollars Sit in Money-Market Funds These investors certainly have money to invest if they choose to. Rob Lutts, founder of Cabot Money Management, notes that $3.7 trillion is sitting as cash in money-market funds, earning interest of less than 1%. That's $2 trillion more of investors' portfolios in cash than at the worst stage of the last bear market in 2000 and 2001.

Movement of all that cash into stocks is not a foregone conclusion, of course. Krosby notes that the market rally could easily lose steam if too many companies report weak results or lower guidance for the rest of the year.

However, she says: "Once [institutions] feel more comfortable about the outlook, you're going to see them putting more money toward equities." And once committed, she adds, those investors will be less fickle than traders, providing the stock market with some stability.

So far, companies have beaten earnings expectations in the second quarter thanks to very deep cuts in expenses. While sales figures remain dismal, cost-cutting, and especially layoffs, are helping companies maintain profit margins. That makes Addison's Church wary. "It's great that productivity has gone up," he says, but "you can't cut costs forever."

Tanglewood's Merrill, however, says all that cost-cutting could boost profits in the next few quarters, even if the economy does not recover strongly. A stable economy could allow companies to increase sales slightly and at the same time provide a big boost to profits at these newly lean companies, he says. "Corporate earnings could be spectacular down the line."

But it could unravel quickly. Such a boost to earnings could be only temporary if the economy does not recover soon. Big institutions, now just dipping their toes into the market, could be scared off by weak earnings reports or bad economic data. And while the stock market rally could boost consumer confidence, the reverse is also true: An unexpected drop in stocks could wound the economy.

For now at least, many investors believe the market is headed higher. But it's difficult to be very confident about a big rally in the midst of a recession based on tenuous logic.
Steverman is a reporter for Bloomberg News in New York.

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