Is this stock market rally for real?

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

For the past quarter century, many individual investors followed a fairly simple investment strategy: set aside regular savings to invest, buy a diversified basket of holdings and ride out the occasional pullbacks by staying focused on very long term returns. That conventional wisdom generally paid off.

Now, with the stock market rallying after a crushing 40 percent decline last year, that strategy seems to be making a comeback. But there are very unconventional forces at work today that may derail that method.

After last year’s heart-stopping plunge, the stock market has gained about 25 percent since it bottomed in November. That stoked confidence among some investors and financial advisers that the worst may be over and investors who bailed out last year should now go bargain hunting.

“Stocks are cheap right now. There's a lot of cash on the sidelines, and earnings are washed out,” said Rob Morgan, a market strategist for Clermont Wealth Strategies. “We've got ingredients for positive things to happen.”

But there are also signs those traditional market signals may be flashing false positives. Here are five reasons to tread carefully.

The coming economic revival
The biggest force propping up stocks now is widespread confidence that the government is moving aggressively to revive the battered economy and credit markets. That confidence rests heavily on reports that the incoming Obama administration is readying a massive package of tax cuts and government spending to pull the economy out of its tailspin. Merrill Lynch economist David Rosenberg has dubbed the market’s recent market gain a “shovel-ready rally” — one that assumes the economy will get back on track by the middle of this year.

“The market may be focused less on the patient right now and more on the cure,” he wrote this week. “This, in turn, means that the doctors better come up with something that is going to turn the economy around.”

But the positive impact of the stimulus package is far from assured. Since last spring, the government has thrown $165 billion in stimulus and rebate checks at the economy, along with $350 billion to buy up bank assets — all on top of a $1 trillion-plus pump priming by the Federal Reserve, which also has pushed short-term interest rates to near zero.

So far, the results have been mixed. Consumers used their rebate checks to save or pay down debts, not spend. Banks have used their newfound billions to bolster battered balance sheets, not lend.

With most economists looking for those measures to begin working by the second half of the year, any delay in that recovery could spell big trouble for investors, according to Joe Battipaglia, a market strategist at Stifel Nicolaus.

“Investors can get very impatient — read that as they become very nervous — when the stimulative activity doesn't take hold, where the Federal Reserve has stayed at zero for a long period of time yet the private sector is still in contraction,” he said.

Fed to the rescue
As the market waits for Congress to act on more stimulus, the Fed has been aggressively pumping money into financial markets.

Investors have also been conditioned to believe that when the Fed floods the system with money, the market responds. Perhaps the most dramatic demonstration came following the Crash of 1987. Stocks dropped 508 points, or almost 23 percent, on Oct. 19, 1987. When word spread that the Fed had opened the financial sluice gates, stocks surged the very next day.

Since it began pumping money in September, the Fed hasn’t loosened up the gears of the economy. Businesses are still cutting jobs and consumers are keeping their wallets shut. Despite committing over $1 trillion, through a maze of lending programs unprecedented in the Fed's 96-year history, economic data continue to point to a steep decline.

“It's impossible given all the government intervention to really figure out what's going to happen this year and when bottoms of markets are going to take place,” said Doug Dachille, CEO of First Principles Capital Management.

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