How long can the market continue to rally with an absence of genuine economic growth? July's gain of 7.82% in the S&P 500 puts that index's five-month return at over 34%. Although the housing market is starting to show recovery, the jobless rate continues to increase, retails sales are abysmal, and most of the gains in earnings from the last quarter have come from productivity gains.
Although the current price/equity ratio of large-cap stocks is around 16.5–right at its ten-year average–investors apparently believe that in the next quarter, the economic stimulus will result in a big boost of consumer confidence, which will jump-start the economy and result in a boost to employment. At the same time, increased earnings will fill the coffers of the U.S. Treasury, reducing the outsized deficit that has been created by the banking debacle of 2008. As a result, one of the biggest risks that mutual fund managers face is missing out on a huge rally. The capitulation of professional investors will only serve to drive the market higher, the logic goes, which will further boost the fortunes of those fully committed to the U.S. equity market.
A prudent investor should consider the ramifications if this best-case scenario fails to materialize. A dismal Christmas season for retailers is likely in the cards if consumer confidence and employment don't start improving. Fiscal stimulus can only last so long, and a flight to quality should not be ruled out if GDP growth proves elusive. Reality will most likely be between these two extremes, but investors should have an action plan if the outcome is more like the latter than the former.
