COLUMN-Four reasons why boomerang effect will prolong stock rally

Mon Apr 1, 2013 3:00pm EDT

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By John Wasik

CHICAGO, April 1 (Reuters) - This is no April Fool's day joke, but catastrophes are good for stocks - eventually. The market usually boomerangs into massive rallies in the wake of them. That's what seems to be happening now, which sustains the argument for a continued rally after the S&P 500 index and the Dow Jones Industrial Average hit new highs last week.

You can see the herd-like movement of mass emotions play out in history. John Maynard Keynes called it "animal spirits" - the spontaneous optimism that causes investors to keep buying.

I was not surprised to learn that the greatest stock rally in American history was after the catastrophe of World War One: between 1921 to 1929, the market gained about 500 percent, according to the Leuthold Group, a Minneapolis investment research firm.

The war claimed millions of lives, followed by a recession and global flu pandemic, yet industrial and home production boomed in the United States after the war ended. And the great American consumer culture took root during that period, as advertising grew along with it to sell everything from autos to soap.

Then, of course, the overheated and over-leveraged economy came tumbling down at the end of 1929, triggering nearly two dismal years. But in the wake of that catastrophe, a genuine surprise in the form of the century's second-biggest rally lasted from 1932 to 1937. This may be hard to believe, but stocks rallied almost 400 percent during that period at the height of the Depression. Wall Street and key business leaders thought the economy had turned the corner.

Even more amazing was that the market gained some 130 percent during World War Two from 1942 to 1946 as war-related industrial activity effectively ended the Depression. Then the post-War rally proved even stronger, showing a 222 percent gain from 1949 through 1956 as America built suburbs, cars and appliances for growing families.

The meltdown of 2008 is the focal point for the latest rebound as it's clearer that the recovery seems to be solidifying. When things seem to be getting back to normal, confidence returns, consumers and business start purchasing and corporate profits rebound. The current rally has been going since March of 2009 - almost 49 months - in the wake of this young century's worst financial debacle. With improving economic figures emerging every month, it may have a way to run.

There's a groundswell of good news that will sustain the current rally, barring any new crises. Here are some of the factors that will propel it:

1) A housing shortage. Who would have ever thought that we'd be facing a shortage of homes this soon after the housing slump? Yet a combination of low interest rates, tight supply and pent-up demand are behind this trend, which may last for a while. The number of homes for sale is at its lowest point since 1999, according to the National Association of Realtors. Now, growing employment and the fact that investors snapped up millions of foreclosures have put a squeeze on home inventories in most regions.

The demand now exceeds the supply and it's still a good time to buy housing with mortgage rates low. This squeeze will boost home prices further and enhance the "wealth effect" people feel when their home equity is growing. That generally favors more stock buying.

2) Employment is showing continued improvement. If you've landed a steady job, you may want to buy appliances and new wheels. That improves the profits of a wide range of manufacturers of consumer durable goods from Whirlpool Corp to General Motors Co.

The unemployment rate - at 7.7 percent - is the lowest since 2008. While that's still too high, it seems to be heading south.

3) Stock prices are not unreasonably high. It's incredibly difficult to argue that stocks are headed into the bubble zone now. The Shiller CAPE Ratio, a measure of historical stock values, is at 23, above its median of about 16, but nowhere near the level during the dot-com bubble at 44.

4) Momentum is building across the board. If the economy was just benefiting from better housing and employment, that might not be enough to jump start the momentum engine. But consumer spending, factory production and business purchasing are also accelerating.

Macroeconomic Advisers, a forecasting firm in Washington and St. Louis, said that U.S. gross domestic product would climb at an annual rate of almost 3 percent in the first quarter, compared with to a 0.4 percent gain in the fourth quarter last year.

Unless Congress overreaches and pares federal spending in a draconian way that goes beyond the current automatic budget cuts required by the so-called sequester, it will be difficult to brake the present momentum. Much of it is still gaining a tailwind from demand that has been building in the wake of the 2008 meltdown.

All this bodes well for homeowners and diversified stock buyers. I have no idea how long this will last, but as long as the recovery seems to be in motion, there's no sense in fighting it.

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