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This Market Rally May Be for Real


Better policy and a shrinking trade deficit, in addition to clues from history, argue for muted optimism

Predicting the stock market is a dicey game. Back in October 2008, when the Standard & Poor's 500-stock index was at 940, I announced on my blog Economics Unbound that I was moving some money back into equities. At the time, I wrote: "Even if the market and the economy keep going down for a while (including today!), this strikes me as a good time to invest."

After that ill-fated post, the market went into a tailspin, hitting a closing low of 677 on Mar. 9. Stock prices, adjusted for inflation, fell back to 1995 levels, wiping out almost 15 years of gains. Many investors wondered why they even bothered.

But now, with stock prices up 20% since the low, I'm ready to take another shot at calling the bottom. The reasons for muted optimism: better policy, small signs of economic revival, and a sense that we already have absorbed a punch of historic proportions. The downside: stubbornly high unemployment.

not as vulnerable

What are the arguments that this rally will not fizzle out soon? Since the low point, the Federal Reserve and the Treasury have unveiled plans to pour as much as $2 trillion into the financial markets. That's a lot even in an economy as big as America's. "I don't think anyone is doing backflips and saying 'mission accomplished,'?" says Ethan Harris, co-head of U.S. economics for Barclays Capital (BCS). "But the basic difference is that policy has entered in full force."

Meanwhile, the economy has shown tentative signs of coming back to life. For example, on Mar. 25, the Census Bureau announced that new orders for durable goods, such as computers, rose by 3.4% in February, the first gain in seven months. Equally important, the trade deficit in January narrowed to an annual rate of $430 billion, or 3% of gross domestic product. That's down from 5% a year ago. As the trade deficit shrinks, the U.S. has to borrow less from China and elsewhere to finance imports. That, in turn, means America's financial markets become less vulnerable to turmoil in other parts of the world.

History also offers clues about the future. The positive news: The average financial crisis has resulted in a 55% real drop in stock prices, according to economists Carmen M. Reinhart of the University of Maryland and Kenneth S. Rogoff of Harvard University. If U.S. stock prices stopped falling now, that's almost exactly what our decline would be, putting us in line with experience. The bad news from history: The U.S. equity slide is only 17 months old, while most equity downturns triggered by financial crises last three years or more. "I don't think we can take too much encouragement in the fact the S&P 500 reached the typical fall of 55% so quickly," Rogoff says.

what could go wrong

Plenty of things could still go wrong. The sudden insolvency of a few governments in Eastern Europe or elsewhere could snuff out investor optimism. Joblessness in the U.S. poses a challenge, too. According to Reinhart and Rogoff, the typical financial crisis pushes up unemployment by some seven percentage points over five years. If the U.S. follows that pattern this time, the jobless rate would rise until 2012, eventually reaching 12%. With so many people out of work, companies would struggle to make good profits.

For sure, stocks could suffer another downward lurch. But despite the collapse that lies behind us and the undeniable problems ahead, this might be the moment when the market begins its next sustained climb.

Mandel is chief economist for BusinessWeek.

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