We're Rallying, but for All the Wrong Reasons

Although the stock market has returned approximately 10% per year historically, the returns since the Dow Jones Industrial Average (DJINDICES: ^DJI  ) and S&P 500 (SNPINDEX: ^GSPC  ) bottomed in 2009 have been almost unbelievable.

Source: Marcy Hargan, Flickr.

Since both indexes hit rock bottom in March 2009, investors have seen the Dow Jones add 136% from its lows, while the S&P 500 gained an even more robust 150%. On an annualized basis, and including the five months since March of this year, the Dow Jones has returned about 21% per year since March 2009, while the S&P 500 has delivered a compounded growth rate of 23% over the same period.

The reason for the market's voracious rally from its lows seems pretty straightforward: the financial system found a bottom, the housing market rebounded, low lending rates spurred growth, and unemployment is on the decline. The reality, though, is that things aren't so cut-and-dried as many would like to think, and many of the reasons we've been rallying just don't make sense. In other words, the market is now rallying for all the wrong reasons.

Wrong reason No. 1: The housing market is rallying because home buyers are taking advantage of low lending rates to buy into new homes, and homebuilders are keeping inventory low in order to preserve their margins.

The reality: The rally in the housing sector looks to be driven less by prospective home-buyers and more by investors. According to the Campbell HousingPulse Survey conducted just a few months ago, home purchases made by investors have climbed from about 15% in 2010 to about 22% of all home purchases in May 2013. These figures are even more pronounced in damaged homes, where investors represented 68% of all purchases compared to just 19% of first-time home buyers, as well as depressed markets like Florida and California, where investors account for more than 25% of overall purchases. Even the Blackstone Group (NYSE: BX  ) has been getting in on the action, purchasing some 26,000 homes in nine states to take advantage of reduced home prices.

However, investors seem to have forgotten that an investor-driven bubble -- not a demand-driven bubble -- is what damaged the housing sector in the first place. Just imagine what could happen to these investors and the housing sector when the Federal Reserve begins paring back its monetary-easing program and lending rates that have been kept artificially low begin to rise. Here's a hint: It's probably not going to be pretty!

Wrong reason No. 2: Investors would point to strong merger-related activity as a sign of economic strength. Specifically, merger activity in today's economy would point to businesses' willingness to use their cash and take on extra risk.

The reality: The fact of the matter is that a good chunk of merger-related activity in recent months has been conducted not out of strength, but out of necessity.

PC maker Dell, for instance, is trying to go private via its co-founder and private-equity firm Silver Lake because Michael Dell doesn't believe his company can complete a turnaround amid transitioning PC sales while in the public's eye. Office supply chains OfficeMax and Office Depot are merging in an effort to better compete with Staples and other online retailers that are handily undercutting them on price and expenses. US Airways is merging with American Airlines following American's bankruptcy filing in late 2011 in the hope that the combined airline will help trim costs and stave off yet another major airline bankruptcy.

Even back in 2011 we saw Global Crossing purchased by Level 3 Communications in what could still be one of the worst deals of all time. Level 3 has produced 54 consecutive quarterly losses, and it purchased a company that emerged from a $30 billion bankruptcy in 2005. If this is the kind of hope we're basing this rally on, we're toast!

Wrong reason No. 3: Since the unemployment rate hit a peak of 10% in October 2009 it has been on a relatively steady decline to 7.4% in July, its lowest reading since the end of 2008. The premise here is that with jobless claims falling and the unemployment rate heading lower, the jobs market must be improving.

Unemployment rate by percentage. Source: Bureau of Labor Statistics. 

The reality: If part-time work or being discouraged into retirement by the difficult job environment is your thing, then this has certainly been the jobs market for you! Jobless claims may be falling, but part-time jobs made up more than 65% of all job creation in July. A big reason behind this shift toward part-time employment likely has to do with the coming implementation of the Patient Protection and Affordable Care Act, known affably as Obamacare. Although the employer mandate has been given a free pass until Jan. 1, 2015, businesses haven't been waiting to get their workers under 30 hours each -- the full-time weekly cutoff outlined by the bill, which requires employers to offer health care insurance to their employees. Earlier this year, Regal Entertainment (NYSE: RGC  ) , the nation's largest movie theater chain, cut hours for thousands of workers in order to get them under the 30-hour threshold -- and it squarely blamed Obamacare. 

The other reality of the jobs picture is that it's still more than twice as hard to get a job now as it was roughly five years ago. Since May 2008 the average duration of unemployment has more than doubled from a seasonally adjusted 16.6 weeks to 36.6 weeks as of July 2013. The reduction in the unemployment rate seems to owe largely to people being forced into part-time work or simply becoming so discouraged that they drop out of the labor force altogether or go back to school.

Wrong reason No. 4: Historically low lending rates are encouraging businesses to take on debt and expand their workforce, which should ultimately translate into revenue growth.

The reality: Rather than generating a huge boom in business, about the only thing low lending rates have spurred is a huge rush by corporations to refinance their debt. Don't get me wrong -- refinancing debt to a lower interest rate is a good thing for businesses, and it will help them save money over the long run. However, instead of reinvesting the money they're saving back in the company or in hiring, most companies have chosen to sit on that cash or simply repurchase their own shares in order to artificially inflate their bottom lines. With quantitative easing nearing an end and businesses spoiled by low lending rates, it could be a while before we see any uptick in borrowing and hiring activity.

Wrong reason No. 5: Newer technologies and products are paving the way for big stock-market gains. Revolutionary new products will change how we communicate and get from point "A" to point "B," which will trickle down and benefit the economy.

The reality: Investors are backing the wrong horse -- or at least trying to ride a horse at full sprint that hasn't even qualified for the race yet. Cloud-computing, for example, will almost assuredly revolutionize how data is stored and shared via the Internet. However, a vast majority of cloud-based providers are unprofitable, yet many have rallied even more than the Dow or the S&P 500.

Another great example is Tesla Motors (NASDAQ: TSLA  ) , which has the opportunity to change the auto industry but doesn't have the infrastructure in place or the production to command even 25% of its current price. We investors are notoriously good at jumping the gun when new technology rolls around, and this looks like just another case of overzealous investing in newer technologies and products.

Wrong reason No. 6: A majority of S&P 500 companies are topping their EPS estimates, signaling to investors that profits are growing faster than expected and the U.S. economy is healthier than any economists had imagined.

The reality: It appears that cost-cutting, rather than top-line revenue growth and business expansion, is driving the majority of earnings beats. With roughly 87% of S&P 500 companies having reported earnings through the end of last week, 72% topped Wall Street's EPS expectations, but only 56% beat the revenue consensus. This figure was even worse in the first quarter, when roughly half of all S&P 500 companies failed to hit the Street's revenue forecast.

Cost-cutting and share repurchases have been the go-to method of boosting bottom-line profits since the recession. As I said before, there's nothing wrong with trimming costs to maximize efficiency, and share buybacks can certainly improve shareholder value. But cash spent on share buybacks is often squandered, and repurchases can mask stagnant top-line growth.

Things are getting real
The reality is that our validations for this rally changed many quarters ago, but investors have been fooled by a lot of smoke-and-mirror tactics into believing the market is in great shape. If you dig a bit deeper, you'll discover that this data isn't so rosy as it appears, which leaves in serious doubt whether or not the indexes could, or should, head higher from their current levels.

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Comments from our Foolish Readers

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  • Report this Comment On August 13, 2013, at 7:41 PM, OceanJackson wrote:

    Fantastic article. I think you nailed the big headline reasons most cite for the continued Bull Market, and your counter arguments for each are pretty strong.

    Nice work.

    A few thoughts. This has been labeled the 'jobless recovery.' But there are jobs available. We just have a drastic skills gap. Secondly, lots of jobs have gone away that just aren't coming back, replaced by technology and improved efficiency. Companies aren't hiring back those jobs because they don't need them.

    Second, there's one more ultra macro claim that I think hovers above all of the accounts for all of your "Wrong Reasons" in that it explains both why we are smoke and mirroring them, and, it further supports that they in fact are wrong:

    The gap between The Rich, over the middle class and poor, is widening to a cataclysmic level. But it is one of those things, due to greed, elitism, classism, and sheer love of power, that can't be fixed, until the Armageddon point - the point when the system crumbles.

    In my opinion, this is the next great Crash. The other stuff is just symptomatic.

  • Report this Comment On August 13, 2013, at 7:51 PM, Agnes59 wrote:

    In regards to TSLA. You stated investors are backing the wrong horse. Who do you think should I be backing up? I believe in new technology and vision that Elon has. Furthermore, my stock is way alot higher now when I bought it at $21.00. So who do you think in the auto industry can top that since this company IPO in 2010. If weren't for Elon, other companies wont be taking EV"s seriously.

  • Report this Comment On August 13, 2013, at 8:53 PM, rhealth wrote:

    This is a very pessimistic article. I dont say that as a criticism of critical thinking generally, but more as a criticism of your ability to read market cycles. Whatever dips we may experience short term, I believe the long term direction is up.

    You seem to assume that expectation and reality should match each other, but they never do. That is what speculation is all about. That gap is where the money is made. The vision of industry leaders pulls the earnings reality, but people dont like it "oh the numbers have to match up" they say. That's crap, they never do. So they get discouraged for a while and pout.

    Because of this cycle of unrealized expectations, they dont like Tesla. people get spooked by the valuation jump out of the stock and say "I told you so" but they fail to understand the big picture and the need for growth and innovation in a healthy economy.

    I believe the mood exists for a company like Tesla where previously it would have failed miserably. Some think Elon Musk is unique, he is not. There are astonishingly innovative people out there. A 17 year old girl just figured out how to make plastics from banana peels.

    We sat here saddled with this auto oligopoly for how many years? Now someone comes along and makes them realize how bloated and unadaptable a big company can be in changing times. Some folks get very nervous about this change in paradigm. It's understandable. It killed Detroit, one of the cities this nation was built on!

    The answer, my friend, is blowing in the wind. The answer is blowing in the wind.

  • Report this Comment On August 14, 2013, at 12:22 AM, Stymie67 wrote:

    Not much real evidence here to support your claims, just opinion. Your opinion may turn out to be correct, but just saying...

    I do think by the looks of it you do not understand Tesla and its business model. You have real kahunas to short that company, I'll give you that.

  • Report this Comment On August 14, 2013, at 8:49 AM, drax7 wrote:

    Empty words and empty opinions. Your comment on tesla invalidates the rest of your article in my mind, if you can be so wrong about that the rest is suspect.

  • Report this Comment On August 14, 2013, at 4:49 PM, OceanJackson wrote:

    I think facts were cited in defense of each claim - not empty opinions.

    Not sure how you could interpret this as an opinion piece.

    I think he's showing you the smoke and mirrors, and then telling you what the reality is.

    Think about it - where's the's to spin bad news into good. Follow the money.

  • Report this Comment On August 14, 2013, at 5:02 PM, cmfhousel wrote:

    The Dow rallied 5,000-plus points before housing bottomed. I don't think it's logical to say rising home prices are a major reason for the stock really.

    To ask if the rally is justified, you have to also ask if the 60% crash through March 2009 was justified. Given that corporate profits quickly returned to all-time highs, I think it's clear that it wasn't.

    <<Just imagine what could happen to these investors and the housing sector when the Federal Reserve begins paring back its monetary-easing program and lending rates that have been kept artificially low begin to rise. Here's a hint: It's probably not going to be pretty!>>

    The Fed temporarily ceased QE in 2010 and 2011. Both times, interest rates *fell* when the Fed backed away.

    As long as the Fed displaces as many private bond buyers as it replaces, it's not at all clear that rates are artificially low.

  • Report this Comment On August 14, 2013, at 5:46 PM, OceanJackson wrote:

    Great points TMFHousel.

    Sean did come out and claim housing as a reason for the rally.

    But I would contend that whether or not it in fact is - it certainly is touted as a major driving force in the mainstream financial media.

    So it is still helpful to dispel, even the onerous reasons, because they are widely held.

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