The Stock Market's Fragile Rally

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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 BusinessWeek's Investing channel.

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