The Rally That Wasn't Supposed to Happen Continues

Then one day you find
Ten years have gone behind you
No one told you when to run
You missed the starting gun

-Pink Floyd

Three years ago, in March 2009, the S&P 500 reached a low of 672.

Investor mood was understandably downbeat - the credit crisis had taken a toll on the economy, and most of the talk centered on recession, rising unemployment, and government bailouts.

No one wanted to buy stocks - equities had failed to deliver on the promise of longer run returns.  No, the most successful investors three years ago were those that had placed outsized bets against the U.S. housing markets, like John Paulson.

The S&P 500 has now doubled in three years. 

Indeed, had you bought stocks in March 2008 - right before the collapse of Lehman Brothers lead to a near total collapse of the financial system - you made nearly +15% on your money. Not a spectacular return, to be sure, but much better than cash or even intermediate Treasury notes.

Yet investors continue to flee the market.

Retail investors have been continually selling their equity positions in favor of bond funds, despite the prevailing low level of interest rates.  Most pension and endowment funds have been continually cutting their positions in publicly traded equities in favor of bonds or alternative investments like private equity and commodity funds.

Could stocks continue to go higher?

While it is certainly possible that we could see a market correction - after all, the S&P is up +11% year-to-date - I think that stocks could continue to move higher.

Here's a quote from one market strategist on CNN:

"This market's got legs," said Doug Cote, chief market strategist with ING Investment Management, whose year-end target for the S&P 500 is at 1,425. "We now have an effective fence built around Europe's debt crisis, and can focus on the underlying strength in fundamentals."

Cote said the biggest driver of stocks will be robust corporate earnings. In 2011, companies in the S&P 500 booked the best profits in history. While the pace of growth is expected to slow, Cote said earnings will continue to come in at record levels. 

"How can you not be in the equity market when we're seeing all-time highs in corporate profits?" asked Cote. "We're advising our clients against waiting for a pullback because we don't think they've missed the big rally -- the market has a ways to go before it catches up with fundamentals."

http://money.cnn.com/2012/03/14/markets/stocks-bull-market/

Yet widespread doubts persist.  For example, the Financial Times carried a piece that basically said, yes, the market indices are reaching new highs, but this is only because a few stocks like Apple are moving higher so strongly:

Fears about the sustainability of the Wall Street bull run have grown, with many stocks sitting out a rally that has taken the S&P 500 to a fresh post-crisis high. 

There were 72 stocks in the S&P 500 that hit 52-week highs on Tuesday, according to data from FactSet, compared with more than 100 when the market last peaked on April 29 last year. 

http://www.ft.com/intl/cms/s/0/0b4c4962-6d16-11e1-a7c7-00144feab49a.html#axzz1p6IZteTD

The article goes on to note, however, that 83% of the industry groups moved higher last week, perhaps contradicting the idea that only a few stocks are driving this market higher.

So here's where we are:  investors continue to hope that stocks move lower, and that interest rates stay around 2% or lower so that the bond investor is rewarded for their caution.

But here's what's happening:  stocks are moving higher, and interest rates are spiking higher as well.  The 10-year Treasury now yields 2.25%, up 45 basis points from the end of January 2012.

There's an old Wall Street expression that discusses "the Pain Trade". This occurs when markets move in the direction that the consensus does not anticipate.

And right now there's a lot of pain going on.