“No, this stock market rally is not for real”

In Time´s The Curious Capitalist, Michael Sivy poses the question “Is this Stock Market Rally for Real?:

Last week, the Dow reached the 13,000 mark for the first time since 2008, despite the daunting problems facing the global economy. This is suggestive of the old Wall Street saying that the stock market climbs a wall of worry. Investors tend to hold cash during economically uncertain times. And so, when their worst fears fail to materialize, they’re in a position to invest. By contrast, when investors are most confident, their money is, for the most part, already invested. As a result, the best rallies often occur when investors go from being very worried to somewhat less worried.

There’s just one catch: It’s not hard for investors to slip back to very worried pretty quickly. If the economy fails to keep improving, today’s rally could easily sputter out. Given that the economy seems to have picked up recently and that average share prices have doubled from their 2009 lows, it makes sense to consider whether investors might have become overly optimistic.

Since the crisis turned “ugly” in the fall of 2008, we notice a positive correlation between the stock market and inflation expectations. This “theme” has been well covered by David Glasner. In “normal” times the two series go “their own way”, but these are not “normal” times.

As Michael Sivy argues, it´s not hard for investors to slip back to very worried pretty quickly and, as the chart shows, that has happened when inflation expectations “retreat”, which tends to happen when monetary policy is seen as failing to support economic improvement. And since the FOMC has alternated between “on” and “off”, so has the stock market and inflation expectations.

No, investors have not become “overly optimistic”, they are just “riding” the “sentiment wave”. And it´s a pretty “foamy” wave.