Is this stock market rally for real?

Buy and hold
The conventional wisdom of modern investing also holds that investors who hang on during market pullbacks will be rewarded eventually. Bullish advisers are also quick to point out that the biggest gains often occur early in any rally, and that it can be difficult to see them coming. Until recently, market pullbacks were relatively short-lived, which helped support the “buy and hold” philosophy adopted by many long-term investors for a generation.

But over the years, that long-range approach has been less reliable. During protracted periods of economic breakdown, like the 1930s and 1970s, short-lived market rallies were followed by devastating pullbacks — leaving buy-and-holders with negligible gains. That kind of market calls for an entirely different set of investing skills, according to Tobias Levkovich, chief U.S. equity strategist at Citigroup.

"You can get very significant rallies, but investors who stick with a buy-and-hold strategy are probably not going to be the winners,” he said. “It's people who can trade more effectively."

Cracked nest eggs
The bull market that began in 1982 was fueled in part by a dramatic shift in retirement savings after the creation of individual retirement accounts like company-sponsored 401(k) plans. Most participants who opted to make regular contributions followed the “buy and hold” strategy,  making relatively few changes to their holdings. That steady stream of cash helped the stock market produce one of its strongest 25-year gains in history. More recently, the popularity of 529 college savings plans have created a new pool of savings that flowed into stocks.

But last year's historic stock market pullback — the worst annual performance since 1931 — may have soured some of those investors to stocks for a long time.  Investors who are near retirement age have limited time to bear additional losses. Some 36 percent of Americans 45 and older say they’ve stopped putting money into a 401(k), IRA or other retirement account — up from 20 percent in October, according to a recent survey from AARP.

Younger investors who are starting to build retirement accounts may think twice before investing heavily in stocks after seeing the recent losses.

And as more baby boomers reach retirement age, they will become sellers of stocks. Many of them are saying they already lost a large portion of their retirement savings and will have to work harder to make ends meet with what they have left.

“We don't know if we will live long enough to see any recovery,” wrote one msnbc.com reader from Pennsylvania. “I guess the only answer to our dilemma is to die 10 years sooner than we had expected.  Or perhaps us old folks can get a job as Wal-Mart greeters.”

Are stocks really 'cheap'?
One of the most compelling arguments for putting savings into stocks today is that they are “cheap” by historical standards. Indeed, with the Standard and Poor’s 500 index marked down roughly 40 percent since it peaked in October 2007, stock prices look almost as cheap as this year’s post-holiday closeouts at the mall.

But that assumes investors will continue to value stocks roughly the same way they’ve done for the past 25 years. One of the simplest ways to judge how much a stock is worth is to look at the underlying company’s profits.

Based on one of the most widely followed measures, the ratio of stock prices to earnings for the S&P 500 stood at about 15 at the end of the third quarter, the latest available earnings. That’s near the average price-earnings ratios tracked by S&P since 1936. So the conventional wisdom argues that as the economy recovers next year and companies begin posting higher profits, stock prices should follow.

But that scenario assumes investors will continue to pay the same price for each dollar of earnings that they’ve a paid for the past 25 years. During that period, the p-e ratio for the S&P 500 has ranged between 10 and 46 (during the height of the tech bubble) and it averaged over 21 (higher than the long-term norm).

Since 1936, the stock market has traded for extended periods at a p-e ratio well below the long-term average of 15.7, however. From January 1977 until September 1982, for example, the S&P 500 never traded above 10 times earnings, and the average for that period was 8.3.

Analysts surveyed by S&P currently expect that multiple to continue to fall next year — to 12.8 times earnings. If the economy were to hit another prolonged bad patch like the 1970s, and that price multiple continues to fall, it could be some time before the stock market finds a bottom.

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