Really, what business does the stock market have setting multiyear highs right now? The U.S. economy grew at an anemic 1.7 percent in the second quarter. It’s creating 139,000 jobs a month on average this year; that is only a fraction of the monthly hires needed to bring the unemployment rate back to pre-crisis levels by 2015. The uncertainty of a close presidential election looms, and no one knows whether Congress and the president will reach an agreement to avert the so-called fiscal cliff—the spending cuts and tax hikes that could stall the economy next year. Europe’s financial crisis remains unresolved.
In the face of all that, Standard & Poor’s 500-stock index is up 25 percent over the past 12 months, and 14 percent in 2012. Stocks have reached levels unseen since before the fall of Lehman Brothers and Bear Stearns. “This is about the strangest market environment I’ve ever seen,” says Donald Luskin, chief investment officer at Trend Macrolytics.
There are some strong forces propelling the rally. Over the long term, stock prices tend to reflect corporate earnings. While S&P 500 profits may decline 1.8 percent this quarter, according to estimates compiled by Bloomberg, they will rebound 11 percent in the final three months of the year, 11 percent next year, and 12 percent in 2014, reaching record levels with every gain. Investors are also counting on help from the Federal Reserve, which is widely expected to start a third round of bond purchases to boost the economy. “The Fed has come out and said that things are weakening and that they’re willing to act,” says Gregory Peterson, director of investment research at Ballentine Partners. And Apple’s (AAPL) success—the stock is up 64 percent in 2012 through Sept. 11—is having an outsize impact on the indexes and the overall economy. With a market value of $620 billion, Apple represents 4.8 percent of the S&P 500 and close to 13 percent of the Nasdaq Composite Index, which has surged to a 12-year high. J.P. Morgan’s (JPM) chief U.S. economist calculates that sales of the company’s iPhone 5, which is being introduced on Sept. 12, could add up to 0.5 percent to annualized fourth quarter U.S. economic growth.
Impressive though that may be, the threats to the market are formidable. Chief among them is the fiscal cliff. Under a law passed last year in the heat of Washington’s debt-ceiling impasse, the failure of lawmakers to agree on some combination of spending cuts and tax increases could result in $1.2 trillion of automatic cuts and accompanying tax hikes in January 2013. That combination could shave 2.9 percent off economic activity in the first half of 2013, according to the Congressional Budget Office. “These are significant risks that the market, in our view, hasn’t really appreciated,” said Goldman Sachs (GS) chief U.S. equity strategist David Kostin at a Sept. 10 conference. Luskin says that even if you assume there’s a 75 percent chance a deal will be struck, that means “25 percent of the time we sail off the cliff and into recession. Would you get on a plane if the pilot told you there was a 25 percent chance it would crash?”
Europe also remains a potent threat, what with Athens having yet to ratify the spending cuts necessary to receive life-or-death bailout funds—and no guarantee that Spain, already reeling from 25 percent unemployment, will agree to more austerity in exchange for the European Central Bank’s financial aid.
There is one wild card that could keep driving the market higher. Hedge funds have woefully missed out on this rally. From the start of the year through the end of August, the main Bloomberg hedge fund index gained 0.5 percent, compared with 13 percent for the S&P 500. “Hedge funds must be sitting on large cash positions or have outsized short positions—how else to explain their underperformance?” says Jenny Van Leeuwen Harrington, chief executive officer and portfolio manager of Gilman Hill Asset Management. High-priced money managers obviously don’t want to finish the year lagging the market by such a wide gap. If they abandon their caution and pile into stocks in a bid to catch up, that belated buying could send indexes even higher, she says.
Individual investors could also decide to get with the program. They pulled money from U.S. equity mutual funds for a fifth straight year in 2011, the longest streak in data going back to 1984, according to the Investment Company Institute. So far this year, they’ve yanked $75 billion. True to form, their timing has been unfortunate.
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