Should You Buy Into This Rally?

On March 6, with the Dow near 6,600 and down 25% since the beginning of the year, a Los Angeles Times financial columnist wrote, "This is the time for hysteria," and explained the different ways he would panic sell all the way down to Dow 3,000.

Ouch.

It's easy to mock such cries of despair in light of the market's subsequent 29% rally, but if you think all the way back to that first week in March, you'll recall that investor panic was rampant.

There was public outrage over AIG (NYSE: AIG  ) asking for even more federal assistance, Citigroup (NYSE: C  ) traded below a dollar, and General Electric (NYSE: GE  ) cut its dividend just a month after the CEO defended the payouts.

Is less bad ... good?
All of that unforgiving pessimism has now been traded in for what looks like blind optimism.

A few weeks back, it was reported that GDP fell 6.1% in the first quarter -- a marginal improvement over the 6.3% drop in the previous quarter, but still far worse than the 4.7% expected by economists. Despite this bad news and mounting fears over swine flu, the market shrugged it off and closed the day up 2%.

More recently, it was announced that the closely watched Case-Shiller home price index fell 19.1% in the first quarter (a record in the 21 years the index has been tracking home prices). Once again, the market shrugged off the bad news largely because consumer confidence returned to September 2008's pre-panic levels.

A number of economists and analysts have taken these "less bad" reports and spun them positively, noting that "the worst of the recession is behind us" and that the data suggest that "the recession may be drawing to a close." In April, an economics professor at Northwestern even proclaimed, "The end of the tunnel may only be weeks away."

If that were true, wouldn't it all be better by now?
Pollyannas aside, there's simply more to the story here. One of the major reasons economists got excited about the latest GDP numbers was shrinking inventories, which they predict means businesses will need to increase orders, which would ramp up production at manufacturers like Dow Chemical (NYSE: DOW  ) and Archers-Daniel-Midland (NYSE: ADM  ) .

But inventories always appear bloated after an economic bubble bursts (think of the post-dot-com-bust warehouse full of Pets.com mascots) and naturally slim down to meet the new economic reality. Until there's an increase in real demand for those products again, who's to say inventories won't remain low?

It's also important to remember that even though consumer confidence has risen, the reading is still well below the average of the past three decades. In their most recent conference calls, for example, major retailers Home Depot (NYSE: HD  ) and Wal-Mart (NYSE: WMT  ) both noted that big ticket sales are still very sluggish.

That's particularly concerning in a historically low interest rate environment that under normal circumstances might persuade consumers to finance larger purchases. Consumers' unwillingness to fork over (or borrow) large sums is an indication that they're still not sure if they'll be able to pay for those purchases, whether the cause is job insecurity, existing debts, or the inability to secure financing.

Earth to Mr. Market?
Bottom line -- the economy, while perhaps "less bad" than it was this winter, is still on shaky ground. In other words, we're no longer falling off a cliff; you might say we're rolling down a rocky hill.

You can't binge on debt for more than a decade and expect a brief hangover. The rebound will happen, but it's definitely not weeks away. As investors, we need to be patient.

That doesn't mean you shouldn't buy into this rally -- but it does mean you should start slow and begin to build positions in companies that are worth owning for the long run.

At Motley Fool Pro, we're skeptical of the sudden optimism -- but we're still finding companies worth buying at current prices. It's our mission to find ways to profit no matter what the market does. We're using options strategies to both generate income and get better prices for the stocks we want to own, and we're using ETFs to hedge against a downturn in the market.

If you'd like to learn more about the advanced strategies we're employing at Motley Fool Pro, simply enter your email in the box below.

Pro analyst Todd Wenning has clowns to the left of him, jokers to the right, but here he is stuck in the middle with Fools. He owns shares of Home Depot. Home Depot and Wal-Mart are Motley Fool Inside Value picks. The Fool's disclosure policy rules Fooldom.


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Comments from our Foolish Readers

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  • Report this Comment On June 01, 2009, at 3:08 PM, counsellor1010 wrote:

    I LIKE GE. IT'S ONE OF THE FEW BIG COMPANIES IN USA THAT "MAKES THINGS".

    MY E-MAIL ADDRESS IS : dyesq@bellsouth.net

    IS IT WOURTH BUYING NOW?

    counsellor1010

  • Report this Comment On June 01, 2009, at 3:49 PM, Matt8265 wrote:

    Market up on volumes roughly 60% of normal. The last of the suckers are buying now.... We've had our three months of greed... now it's fear time.

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