Markets again bet the worst is past

Did they cancel Great Depression II? So soon?

That’s one message investors might choose to take away from the sharp rebound in stock markets worldwide over the last three weeks.

The Standard & Poor’s 500 stock index has pared its year-to-date loss from a stunning 25% as of March 9 to just under 10% at Friday’s close.

The global economy still is in miserable shape after the dive in consumer and business spending since mid-2008. Banks still totter, unemployment keeps rising and corporate earnings are cratering.

But for the moment, Wall Street has stopped anticipating the end of the world, and is figuring we’re just in a very bad recession -- and one that depressed share prices may already largely reflect.

Edward Yardeni, an economist and consultant who heads Yardeni Research in Great Neck, N.Y., senses a change of mind-set among many of his institutional investor clients. “I see more of them wondering if they should become less defensive� in their portfolios, he says.

That’s the natural reaction to abrupt market rallies, of course. Even the most confident bears begin to doubt themselves when share prices rise. They wonder, “What does the market know that I don’t?�

Maybe nothing. This is the fifth time U.S. blue-chip stocks have risen more than 10% since the long slide began in October 2007. The previous four rallies all gave way to more selling and new market lows.

This one hit an air pocket on Friday, when sellers shaved 2% off the S&P; 500 index. Still, the S&P; was up 6.2% for the week, thanks to the warm reception investors gave the Obama administration’s latest financial-system rescue program Monday.

That’s right -- Treasury Secretary Timothy F. Geithner came up with an idea that wasn’t immediately trashed by Wall Street. He provided details of his long-awaited plan for private investors to partner with Treasury to bid for some of the rotten mortgage assets on banks’ balance sheets.

Geithner can’t guarantee that the program will have the desired effect of bolstering banks’ health. Private investors may simply not offer high enough prices to make it worth banks’ while to jettison troubled assets. It may take months to know if it will work.

The stock market’s rally on the news could merely have reflected relief that, finally, all of the components of the government’s rescue plan now are on the table. That list includes the alphabet soup of lending programs created by the Federal Reserve as it pumps trillions of dollars into the financial system to stem the credit crunch.

This shock-and-awe campaign impresses Jim McDonald, chief investment strategist at Chicago-based Northern Trust, which manages $560 billion for clients.

“We think that what the Fed and the Treasury have done has reduced the risk of the worst happening� to the financial system and the economy, McDonald said. Enough so, he said, that he shifted a chunk of Northern Trust’s portfolio out of cash and into stocks and other investments this month, trimming his cash holdings to 11% of assets from 16%.

Also still mostly in the pipeline are the effects of the nearly $800-billion economic stimulus bill Congress approved in February. Ditto for this year’s mortgage refinancing wave, with home loan rates at record lows.

At a minimum, if the financial and economic meltdowns have been arrested it makes sense that investors would have to think twice about sending stocks down further, after taking the S&P; 500 and the Dow industrials to 12-year lows March 9.

Once a market bounce begins it can fuel buying by bearish “short sellers� who had borrowed stock and sold it, betting on lower prices. As they rush to buy shares to close out their trades they feed the rebound.

Short-covering helped drive the previous four rallies. But the effect wasn’t long-lived.

The difference this time, however, is that even the short sellers have to wonder if they’re overestimating how much more damage the economy and the stock market are likely to sustain.

Reports this week showed that sales of both new and existing homes rose in February, albeit from deeply depressed levels in January. Likewise, orders for big-ticket manufactured goods were up last month, the first increase since July. On Friday the government reported that consumer spending inched up in February, the second consecutive gain.

Of 12 economic reports this week, just three were weaker than analysts’ consensus forecasts, according to market research firm Bespoke Investment Group. “While none of these reports can be classified as ‘good,’ the fact that they are beating expectations is a positive sign,� the firm noted in a summary.

The data embolden optimists who believe that the economy shrank in the first quarter at a significantly slower pace than the 6.3% annualized rate of the fourth quarter. The consensus among economists calls for a decline this quarter of 5.2%, according to a Bloomberg News survey.

Next quarter the shrink rate is projected to be 2%. After that, the consensus is for the economy to expand in the second half of 2009, although it won’t be much: 0.5% growth in the third quarter and 1.8% in the fourth.

There are plenty of doubters. Maria Fiorini Ramirez, head of economic forecasting firm MFR Inc. in New York, sees the economy continuing to contract in the second half, at a pace of 1.5% in both the third and fourth quarters.

Despite the recent bump in consumer spending, Ramirez doesn’t see Americans having the wherewithal to spend enough to restore economic growth this year. With job losses rising, incomes will continue to be squeezed, she said: “We think the consumer’s hands are tied.�

If more investors come over to that view, and doubt that a turn in the economy and corporate earnings will happen before 2010, this month’s jump in stock prices may fizzle just as the last four rallies did.

Still, if Wall Street at least believes that the economy isn’t about to fall off another cliff, the market could just be set to bounce along in a relatively narrow range -- paradise for traders (or so they may think), but frustrating for investors who badly need to make up their devastating losses of the last 17 months.

It might be easy for many investors to conclude that a trading-range market would be only slightly less aggravating than another full-on bear market plunge, and that it would be better to just exit stocks altogether.

Human nature being what it is, however, you’ll always wonder if the next upturn in prices will be, at last, the one that sticks. After a horrid bear market, you have to be very risk-averse -- and very resolute -- not to want any stake at all in the equity game.

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