Why Aren’t Stocks Falling?

As SAR notes, the "longer and deeper recession" meme is "becoming the popular view" — it’s increasingly difficult to find people who really think we’ll bounce back in the second half of this year, and economists generally are much more bearish now than they were a couple of months ago.

So why is the stock market up 20% since then?

My feeling, mainstream as it may be, is that stocks are drifting upwards in blissful ignorance of reality, much as they did for nearly all of 2007, even after the credit crisis first hit. The panic sellers and the people desperately needing liquidity have left, volumes have fallen (as they always do around the holidays, no news there), and volatility has decreased. And so both value and momentum players are feeling increasingly comfortable rotating back in to the market.

But if the recession gets to be as bad as people are increasingly expecting, fundamentals will eventually start asserting themselves — and if we’re unlucky, they’ll do so in a violent downward manner, much as they did last fall. Remember that the bond market is pricing in a serious wave of defaults — and I don’t think the stock market is. If and when those defaults arrive, with shareholders of the companies in question being largely wiped out, will the broader indices really remain unaffected? And more generally, a two-year-long recession does really nasty things for corporate profits, which rise much faster than GDP in boom years, but fall much faster than GDP in bust years.

The lesson of the past two years is that the stock market is a lagging, not a leading, indicator. I have no faith in this rally whatsoever; I hope that I’m wrong, but I just don’t see the current stock market reflecting an economy which is hugely reliant on retail spending and where holiday-season sales were the weakest in four decades. It’s always calmest before the storm, and I fear another gale might be brewing.