Soaring Stocks: Rational Investing in an Irrational World?

If you're a stock market bull, you might be interested in the fact that a growing number of investors are ignoring worsening fundamental events and simply buying stock. Already knew that, you say? Since the October low in stock prices, domestic and global fundamentals have been worsening but investors have nonetheless been buying stock at a quickening pace in a rally assisted by the Federal Reserve Board's easing of monetary policy.

Never mind the fact that key Asian economies, including the world's second-largest in Japan, have recently seen their economies accelerate their economic contraction to an annual rate of -7% in Gross Domestic Product; that the Japanese Finance Ministry just admitted that Japan will be in "recession" for two more years; that the Brazilian stock market has plunged 23% this month; that the Russian Ruble just plunged to yet another all-time new low; that the United Kingdom just announced that its year-on-year rate of deflation at the wholesale level is a whopping 8.5%; that eight of the 30 companies that make up the Dow Industrial Average just announced that Wall Street's already downgraded earnings expectations are still too optimistic; that many key companies in the U.S. have announced intentions to lay off tens of thousands of workers; or that the President of the United States is about to be impeached by the House of Representatives. If you're a bull, take no stock in any of that (no pun intended), just buy stock, as the common thinking goes.

While we have observed during this month's correction that there is still enough cash outstanding to easily power the market to new record highs (see our December 8 article, Mutual Funds Are Sitting On Enough Cash To Drive Stocks Higher for more, at http://www.gmsresearch.com), and while there are other "positives" for the U.S. equity market (cycles are positive at this time; Fed is engaged in easy money policy), the current market environment smacks of the type of environment that prompted depression era economist John Maynard Keynes to once say, "There is nothing so disastrous as a rational investment policy in an irrational world."

Keynes was the British economist who proposed that high unemployment is a result of insufficient consumer spending and that deficit spending and government programs would stimulate economic activity. That set the stage for the basics of U.S. monetary policy for decades following the Great Depression of the 1930s, and for President Roosevelt's New Deal plan to bring the U.S. out of the depression.

In present times, rapidly deteriorating global economic fundamentals would seem to have the stock market gripped by a grueling bear market as was the case in similar situations in the past. Indeed, the equity markets of many prominent global economies are gripped by the claw of the great bear. Even rebounding European equities are not close to record highs despite the fact that the Dow Industrial Average and S&P 500 Index have, in fact, recently set marginal record highs.

Yet, the Dow now stands a few thousand points above the level at which Alan Greenspan had dubbed investors "irrationally exuberant" two years ago. Even with a kinder, gentler form of "Greenspeak" in which the U.S. Federal Reserve Chairman later modified his stance by indicating that perhaps higher stock prices could be justified if earnings were to keep pace, Dow 9000 is difficult to justify since earnings have, in fact, not kept pace. Instead, earnings growth has declined substantially in the wake of the Asian economic meltdown, with many corporations announcing earnings warnings this quarter.

Nonetheless, money managers and fund managers underperforming the market during a roller coaster year have scrambled to play catch-up to the benchmark U.S. stock averages after they were caught with very high cash levels at the October low. At the same time, investors have chosen to speculate like there's no tomorrow in technology stocks and anything that has to do with the Internet, where companies selling on the Internet have commanded the attention of investors despite never having earned a dime in earnings (see our archive article, Is Internet Stock Craze The Latest "Tulipmania?". The entire U.S. stock market scenario appears as one in which the rebound from the October low is what would historically have been a several-month rebound compressed into only a few weeks. Even after the 1966 market top and subsequent decline it took two years for the Dow to touch its 1966 record high. A decade ago it took two years for the Dow to set record high after the Crash of '87.

In 1998, however, investors are not so patient despite the worst global fundamentals in decades, and they have left mutual fund and money managers lagging the benchmark averages and scrambling to put stocks in their portfolios rapidly to catch up. Perhaps the present climate consisting of lagging money managers is all just a result of trying to maintain a rational investment policy in an irrational world.