Will The Stock Market's Rally Endure?

I've long been skeptical of the stock market. That's why, despite the pain that this recession caused the stock market in late 2008 and early 2009, I thought a deep market correction was long overdue. Now, of course, the Dow is soaring above 10,000 again, and life for stock brokers seems much better than it did back in March. But I don't buy it. According to an article on Bloomberg today, neither does economist Andrew Smithers, well-known for predicting the bear market in the early part of this decade.

Smithers believes that the S&P 500 is overvalued by about 40% and will drop again, once the Federal Reserve begins tightening its belt. Bloomberg reports:

"Quantitative easing has set off another sharp, and so far containable asset bubble," Smithers said. "But if it gets too high and starts to come down then we'll go straight back" into recession.

So where does his estimate come from? A ratio he developed some years ago:

He based his prediction in the book on Tobin's Q, an indicator of whether the market is overvaluing or undervaluing company assets compared with their replacement cost. He uses both the Q ratio, as well as a cyclically adjusted price-to- earnings ratio compiled by Yale University's Robert Shiller, for his estimate that U.S. shares are 40 percent overvalued.

I think that, even without any fancy mathematical theories, it's almost completely obvious that this stock market rally is premature. The stock market is a leading economic indicator. From what I've heard, there are almost no economists who believe the U.S. economy will recover nearly as quickly and dramatically as the stock market has. Yet, the economy must improve in a similar fashion for the stock prices to have any correlation to the value of the firms they represent. Since it won't, the rally appears irrational.

Moreover, the idea that the stimulus measures might be triggering a false sense of optimism also seems pretty clear. The consensus estimate for GDP growth in the third quarter is around 3%. Without stimulus, those same economists say it would have been around zero. Yet, the stock market is soaring. Stimulus, while helpful, is temporary. If zero is the real trend number, then once the Federal Reserve's and government's efforts disappear, growth will return to the natural path -- resulting in a very gradual recovery.

Of course, that doesn't even take into account the harm to the economy looming tax increases represent. Raising taxes won't happen immediately, but a hefty increase is inevitable. Even if Congress and the Obama administration completely disregard their ambitious agenda (and they won't), the enormous stimulus that was employed during this recession needs to be paid for eventually.

Efficient market theorists (if there are still any around) will scoff at such ideas. They believe asset prices must be right, because they reflect all available information. Smithers has this base covered: he can point to his alternative theory, outlined in his new book:

In the book he proposes a successor to the efficient markets hypothesis, naming it the imperfectly efficient market hypothesis. Smithers, who worked for 27 years at S.G. Warburg & Co. where he ran the investment management business, contends that asset prices rotate around a fair value level that can be objectively measured, whereas efficient market theorists postulate assets are always valued at the correct price and therefore need no regulation by authorities.

I haven't read the book, but after reading Bloomberg's article, I'm kind of intrigued. As someone who studied physics some years ago, the idea that there's a sort of bound for where asset prices should be sounds like a pretty good idea. That's not to say market values are completely useless, just not as precise as people think. Given how quickly and drastically markets move to even the slightest news, I find this hard to dispute.

With all that said, I certainly hope I'm wrong. After recently receiving my third quarter 401k statement, I'm very pleased with this market rally. I just find it unlikely that it could endure, given the broader economic picture.