Why are stocks rising despite bad news?

John W. Schoen Senior producer • Profile • E-mail

With all the gloomy economic news out there, from a nasty housing slump to a weakening job market, some readers are wondering: Why is the stock market going up?

For the past six months, (we’ve seen) a further imploding housing market, a financial market crumbling on several fronts and consumer sentiment/spending beginning a long, slow march south. The problem is that the stock market is not reflecting this reality.  Today the Dow is a mere 2 percent down from a year ago and less than 10 percent off its 12-month high. Isn't the ticker defying normal market psychology, or are the professional investors actually all idiots?
— Tim B., Fort Myers, Fla.

Well, not all of them.

It is a little hard to understand how the stock market is holding up so well these days. We’d add to your list of worries: a weakening job market, rising inflation, sky-high oil and food prices and a shrinking dollar. With all the bad news out there, anyone could be excused for wondering why stocks have been in rally mode for the past month or so.

Since the two magnetic poles that act on investor psychology — greed and fear — are apparently still in force, fear seems to have subsided for the moment and greed has the upper hand. That’s because stock investors are betting not on what’s happening today but on what they think will happen six months from now.

If the worst of the bad news is already known, the thinking goes, now is the time to buy. If all goes well, and the economy starts to recover by the end of the year, a bet on stocks today will pay off then.

If you wait for enough good news to confirm that the worst is over, stocks prices will have already moved higher and it will be too late to buy. As the folks down at the New York State Lottery like to remind us, “You’ve got to be in it to win it.”

So Wall Street’s bulls are hoping that the past year’s interest rate slashing by the Federal Reserve, along with $150 billion in government tax givebacks soon hitting taxpayers’ mailboxes, will give the economy a big enough lift to turn things around. Because those remedies take months to show up in the data, stock market bulls are buying now to get out in front of that hoped-for turnaround.

In past few weeks, stock buyers also have been encouraged by a batch of relatively strong corporate profit reports. Some of those companies, like IBM and Coca-Cola, have big international operations that have benefited from the weak dollar.

That works two ways. First, products priced in dollars are cheaper for customers abroad than competing products priced stronger currencies. And when U.S. companies earn profits overseas, those profits turn into more dollars per widget when they're converted from foreign currencies back into dollars.

Corporate profits are usually a pretty good guide to how well stocks are priced. Unlike a bond, which is backed by assets and a promise to repay your money, a stock is just a claim on a company’s profit stream. So one way to find out if stock prices are too high or low is to compare prices to the level of earnings.

By that measure, stock prices are a little high. The price-to-earnings ratio of all the stocks in the S&P 500 index stood at 22.2 at the end of last year, compared with the 50-year average of 17.5. But current prices are still less than half the bubble-induced high of 46.5 at the end of 2001.

Companies have also been fairly cautious in their forecasts of future profits: If the economy begins bottoming this summer, those profits could well turn out to be higher than expected by the end of the year. And that is exactly what Wall Street analysts are forecasting.

Of course, it’s entirely possible that this line of thinking is wrong and that the recent stock market gains are a "sucker’s rally." The recent upward move needs to continue before the bulls can claim a convincing victory.

In the meantime, a lot could go wrong: Another Bear Stearns or two could blow up, inflation could get out of control, housing prices could keep falling for the next few years, rising unemployment could cut into consumer spending and snuff out any recovery. We don’t presume to have any idea whether the bulls or bears are right on this one.

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