Market rally doesn't look like real thing

Here is a small quiz about stock markets. Prices reflect a) the best available estimate of discounted present values of future cash flows; b) the balance of investors’ fear and greed; c) confusion. In financial theory, “a” is right. In reality, it’s usually better to go for “b”. For the most recent rally, “c” looks like the best analysis.

Most of the world’s major stock markets jumped 10% in just over a single week. That can’t be sneezed at. In the fear-greed analysis, it suggests a little bit less fear – true greed still seems a distant prospect. Grand announcements from several leading banks that they didn’t expect to go under were enough to change the investor mood from total panic to something more like barely controlled panic.

The news isn’t all bad: US and German sentiment is improving in some surveys, a US housing index was stable instead of declining, retail sales in the US and eurozone were higher. The freefall in credit and economic activity that followed the collapse of Lehman Brothers seems over.

But the balance of evidence suggests that rapid decline has been followed by a slower decline. Lending is still weak, credit spreads are moving in the wrong direction and rising unemployment is just starting to bite consumption. And another toxic reaction is possible as the continuing credit squeeze interacts with the deep recession and aggressive fiscal and monetary policy.

We’ve been here before. At the end of last November, stock markets started to behave as if the crisis was almost over. Then the indices rose by 25% in seven weeks, before falling back to new lows. There was too much bad news about carmakers, banks and eastern Europe.

The coming wave of government spending could soon turn things around definitively. Most forecasters expect that. But through all of the last year, the experts have been marking down current expectations, while anticipating a recovery six to nine months in the future. It seems overly optimistic to trust such forecasts now. Rather, it looks like the market has got ahead of the news.