We're Rallying, but for All the Wrong Reasons


Although the stock market has returned approximately 10% per year historically, the returns since the Dow Jones Industrial Average and S&P 500 bottomed in 2009 have been almost unbelievable.

Source: Marcy Hargan, Flickr.

Since both indexes hit rock bottom in March 2009, investors have seen the Dow Jones add 136% from its lows, while the S&P 500 gained an even more robust 150%. On an annualized basis, and including the five months since March of this year, the Dow Jones has returned about 21% per year since March 2009, while the S&P 500 has delivered a compounded growth rate of 23% over the same period.

The reason for the market's voracious rally from its lows seems pretty straightforward: the financial system found a bottom, the housing market rebounded, low lending rates spurred growth, and unemployment is on the decline. The reality, though, is that things aren't so cut-and-dried as many would like to think, and many of the reasons we've been rallying just don't make sense. In other words, the market is now rallying for all the wrong reasons.

Wrong reason No. 1: The housing market is rallying because home buyers are taking advantage of low lending rates to buy into new homes, and homebuilders are keeping inventory low in order to preserve their margins.

The reality: The rally in the housing sector looks to be driven less by prospective home-buyers and more by investors. According to the Campbell HousingPulse Survey conducted just a few months ago, home purchases made by investors have climbed from about 15% in 2010 to about 22% of all home purchases in May 2013. These figures are even more pronounced in damaged homes, where investors represented 68% of all purchases compared to just 19% of first-time home buyers, as well as depressed markets like Florida and California, where investors account for more than 25% of overall purchases. Even the Blackstone Group has been getting in on the action, purchasing some 26,000 homes in nine states to take advantage of reduced home prices.

However, investors seem to have forgotten that an investor-driven bubble -- not a demand-driven bubble -- is what damaged the housing sector in the first place. Just imagine what could happen to these investors and the housing sector when the Federal Reserve begins paring back its monetary-easing program and lending rates that have been kept artificially low begin to rise. Here's a hint: It's probably not going to be pretty!

Wrong reason No. 2: Investors would point to strong merger-related activity as a sign of economic strength. Specifically, merger activity in today's economy would point to businesses' willingness to use their cash and take on extra risk.

The reality: The fact of the matter is that a good chunk of merger-related activity in recent months has been conducted not out of strength, but out of necessity.

PC maker Dell, for instance, is trying to go private via its co-founder and private-equity firm Silver Lake because Michael Dell doesn't believe his company can complete a turnaround amid transitioning PC sales while in the public's eye. Office supply chains OfficeMax and Office Depot are merging in an effort to better compete with Staples and other online retailers that are handily undercutting them on price and expenses. US Airways is merging with American Airlines following American's bankruptcy filing in late 2011 in the hope that the combined airline will help trim costs and stave off yet another major airline bankruptcy.

Even back in 2011 we saw Global Crossing purchased by Level 3 Communications in what could still be one of the worst deals of all time. Level 3 has produced 54 consecutive quarterly losses, and it purchased a company that emerged from a $30 billion bankruptcy in 2005. If this is the kind of hope we're basing this rally on, we're toast!

Wrong reason No. 3: Since the unemployment rate hit a peak of 10% in October 2009 it has been on a relatively steady decline to 7.4% in July, its lowest reading since the end of 2008. The premise here is that with jobless claims falling and the unemployment rate heading lower, the jobs market must be improving.

Unemployment rate by percentage. Source: Bureau of Labor Statistics.

The reality: If part-time work or being discouraged into retirement by the difficult job environment is your thing, then this has certainly been the jobs market for you! Jobless claims may be falling, but part-time jobs made up more than 65% of all job creation in July. A big reason behind this shift toward part-time employment likely has to do with the coming implementation of the Patient Protection and Affordable Care Act, known affably as Obamacare. Although the employer mandate has been given a free pass until Jan. 1, 2015, businesses haven't been waiting to get their workers under 30 hours each -- the full-time weekly cutoff outlined by the bill, which requires employers to offer health care insurance to their employees. Earlier this year, Regal Entertainment , the nation's largest movie theater chain, cut hours for thousands of workers in order to get them under the 30-hour threshold -- and it squarely blamed Obamacare.

The other reality of the jobs picture is that it's still more than twice as hard to get a job now as it was roughly five years ago. Since May 2008 the average duration of unemployment has more than doubled from a seasonally adjusted 16.6 weeks to 36.6 weeks as of July 2013. The reduction in the unemployment rate seems to owe largely to people being forced into part-time work or simply becoming so discouraged that they drop out of the labor force altogether or go back to school.

Wrong reason No. 4: Historically low lending rates are encouraging businesses to take on debt and expand their workforce, which should ultimately translate into revenue growth.

The reality: Rather than generating a huge boom in business, about the only thing low lending rates have spurred is a huge rush by corporations to refinance their debt. Don't get me wrong -- refinancing debt to a lower interest rate is a good thing for businesses, and it will help them save money over the long run. However, instead of reinvesting the money they're saving back in the company or in hiring, most companies have chosen to sit on that cash or simply repurchase their own shares in order to artificially inflate their bottom lines. With quantitative easing nearing an end and businesses spoiled by low lending rates, it could be a while before we see any uptick in borrowing and hiring activity.

Wrong reason No. 5: Newer technologies and products are paving the way for big stock-market gains. Revolutionary new products will change how we communicate and get from point "A" to point "B," which will trickle down and benefit the economy.

The reality: Investors are backing the wrong horse -- or at least trying to ride a horse at full sprint that hasn't even qualified for the race yet. Cloud-computing, for example, will almost assuredly revolutionize how data is stored and shared via the Internet. However, a vast majority of cloud-based providers are unprofitable, yet many have rallied even more than the Dow or the S&P 500.

Another great example is Tesla Motors , which has the opportunity to change the auto industry but doesn't have the infrastructure in place or the production to command even 25% of its current price. We investors are notoriously good at jumping the gun when new technology rolls around, and this looks like just another case of overzealous investing in newer technologies and products.

Wrong reason No. 6: A majority of S&P 500 companies are topping their EPS estimates, signaling to investors that profits are growing faster than expected and the U.S. economy is healthier than any economists had imagined.

The reality: It appears that cost-cutting, rather than top-line revenue growth and business expansion, is driving the majority of earnings beats. With roughly 87% of S&P 500 companies having reported earnings through the end of last week, 72% topped Wall Street's EPS expectations, but only 56% beat the revenue consensus. This figure was even worse in the first quarter, when roughly half of all S&P 500 companies failed to hit the Street's revenue forecast.

Cost-cutting and share repurchases have been the go-to method of boosting bottom-line profits since the recession. As I said before, there's nothing wrong with trimming costs to maximize efficiency, and share buybacks can certainly improve shareholder value. But cash spent on share buybacks is often squandered, and repurchases can mask stagnant top-line growth.

Things are getting real
The reality is that our validations for this rally changed many quarters ago, but investors have been fooled by a lot of smoke-and-mirror tactics into believing the market is in great shape. If you dig a bit deeper, you'll discover that this data isn't so rosy as it appears, which leaves in serious doubt whether or not the indexes could, or should, head higher from their current levels.

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The article We're Rallying, but for All the Wrong Reasons originally appeared on Fool.com.

Fool contributor Sean Williams owns shares of Dell and is short shares of Tesla Motors, but has no material interest in any other companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.The Motley Fool owns shares of, and recommends, Tesla Motors. It also owns shares of Staples. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Originally published