THE BLOG
09/10/2009 05:12 am ET | Updated May 25, 2011

The Ultimate Stock Market Sucker's Rally

By now we've all seen reports about the amazing stock market rally of 2009.

The widely followed stock market measure broke above 1,000 on Monday for the first time in nine months as reports on manufacturing, construction and banking sent investors more signals that the economy is gathering strength.

The day's reports were the latest indications that the recession that began in December 2007 could be retreating. Better corporate earnings reports and economic data propelled the Dow Jones industrial average 725 points in July to its best month in nearly seven years and restarted spring rally that had stalled in June.

If you listen to the financial news long enough you would know that the all-seeing, all-knowing stock market has declared the Great Recession to be over. A 50% stock market rally is indeed impressive and unusual. In fact, it's been 80 years since the last time the stock market has moved so far, so fast.

It's an amazing run-up throughout the last five months, but one that is also very similar to the five-month rally of 48% from November 1929 to April 1930, notes Miller Tabak equity strategist Peter Boockvar.

That rally almost 80 years ago followed the initial crash, and was then followed by a deteriorating stock market and economy.

That's not to say that history will repeat itself, but it is a good example of a stock market rule-of-thumb: the sharpest and most violent stock market rallies always occur during a bear market.

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So is this the start of a new bull market, or a bear market sucker's rally? To determine that we need to decide whether stocks are cheap or expensive. If stocks are expensive then the amount of "upside" is limited. If they are cheap then the amount of "downside" is limited. Let's start by looking at the earnings reports that the financial media mentioned above.

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Looking at the earnings reports it is obvious that they've been a disaster. The reason why the financial media is bragging them up is because the earnings are "only" down about 30% when they were expected to be down 36%. That's a reason for a relief rally, but not for the near euphoria you are seeing these days. And even these extremely poor earnings reports are fictional.

Stock analysts continue to promote corporate earnings lies, insisting that net income isn't really what investors need to know.

Instead, their earnings estimates ignore often huge expenditures that can't help but affect a company's health.

The ultimate way of determining whether a stock is cheap or expensive is comparing their earnings to their price, also called a P/E ratio (price/earnings).

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The trailing P/E ratio has shot up to levels that I've never seen in my lifetime. To say that stocks are pricey is an understatement. And it isn't just the S&P 500 stocks. Nasdaq 100 stock P/E's are also hitting the stratosphere.

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The only way that prices like these can be justified is if the economy is about to roar back in the next 3 months in a way that the country hasn't seen in 26 years.

Is that likely to happen?

Personal income is falling. Home prices have fallen at a rate not seen since the Great Depression.

The commercial paper market is still frozen. The FDIC expects 500 banks to fail in coming months, mostly because the commercial real estate market is imploding.
The Federal Reserve predicts that high unemployment will cause the eventual economic recovery to be drawn out and weak for years to come.

Mark Mobius of Templeton Asset Management is predicting a 30% drop in global stocks this year. He's not alone in his skepticism. An executive at Pimco says the stock market has been on a "prolonged sugar high," and futures trading is revealing nervousness in investors.

Given that almost no one outside of the financial media believes the economy is about to bounce back, what does all the happy-talk about Green Shoots and recovery mean?

It means that the smart money, needs someone to sell to.

Wall Street insiders can't get rich off of each other. That would require talent and skill.

What Wall Street insiders need is what is affectionately known as "dumb money". They need money from 401k's, outsiders, and amateurs. In other words, they need your money to buy their stocks that have been bid up beyond all reason. They need money from people foolish enough to believe what the financial media is telling them.

Wall Street needs suckers.