Common sense says this rally can't last, Commentary - Derek DeCloet, The Globe & Mail, July 31, 2009

Cheaper and cheaper money is driving stocks

Derek DeCloet



When the book is closed on this Great Recession – and it's about to slam shut – it will matter little that this has been the longest the United States has seen in the postwar era, and also the most severe. What will linger is not that trivia, but the trauma. We'll remember it as the slump that left scars.

Recessions of the past would put your job at risk. For millions of Americans – and many thousands of Canadians – this one threatens the job, the house, the pension, the investment account. There is hope, however, and it doesn't come from sightings of “green shoots” by the same economists who never spotted any trouble in the first place. That retirement plan? It's suddenly looking better.

It's amazing what can happen when half of the working-age population is slumbering at the cottage or on the deck. The Dow Jones industrial average has just concluded its best month in nearly seven years, gaining 8.6 per cent in July, but that doesn't capture what has been happening in the equity markets since late winter.

Green shoots, bah; it's more like a tropical rain forest. New life is busting out all over the place. Since the lows of early March, U.S. stocks have gained nearly 50 per cent – that's $3.8-trillion (U.S.) in additional wealth, on paper. And in global terms, the U.S. market is a laggard, a dud. In Canada, nearly half the damage of the stock market collapse has already been undone (that is, we're almost halfway back to last summer's record high). All this while the economy is still shrinking.

Just imagine when the recovery is here. Economic recovery will bring higher corporate profits. Higher profits mean higher stock prices. Higher stock prices mean I won't have to eat Alpo when I'm 65. Can it really be this easy?

No, it can't. Sorry to say it, but it's the truth. Recoveries, economic or financial, are rarely smooth or linear. Besides, growth does not automatically equal rising markets.

Look at your history. Look at the late 1960s and 1970s, an era that included not only stretches of brisk economic expansion but massive innovation. NASA put a man on the moon, Intel created the first microprocessor, Boeing built the 747, Motorola came up with a cellphone prototype (which the company billed, excitedly, as a lightweight “less than three pounds”). Paul Allen and Bill Gates sold their first computer program, giving birth to Microsoft.

And all the way along, the U.S. steadily became a more prosperous place, pulling the rest of the world along with it. Not even the recession, stagflation or oil embargo episodes of the 1970s could halt the trend. By 1981, America's real economic output was 23 per cent higher, per person, than it had been a decade earlier.

Dedicated historians of the stock market know the punchline. On Dec. 31, 1964, the Dow Jones industrial average was at 874. Over the following 17 years, the profits of U.S. corporations tripled, personal incomes rose and wealth grew. And the Dow, that venerable yardstick of Capitalism USA, gained precisely one point the whole time, finishing the year 1981 at 875.

What happened? High interest rates got in the way. Profits were rising, but investors were willing to pay less for each dollar of earnings.

And when you really examine it, that's also what caused the great crash of 2008-09. It was not, as in the tech crash that preceded it, simply a case of a bubble going pop, or of an isolated, overvalued part of the market dragging the index down. This was widespread. It didn't matter whether you owned big companies or small ones, Canadian or American or European or Asian stocks, a blue-chip business (like Cisco Systems) or a risky one masquerading as a blue-chip (like General Electric). They were all losers.

From the day that Lehman Brothers went under to the deepest lows of March, 492 of the stocks in the Standard & Poor's 500 went down. That's nothing at all like what happened in the tech bust.

Simply put: In the panic, a dollar of future profit became worth less than it used it be. And that – the crunching of the value of nearly every business, everywhere, simultaneously – was all about the cost of debt, period. As it rises, equity prices must fall. It's simple math. If a company can borrow money at 5 per cent, then its shareholders, being at the back of the line, demand to make at least 7. But when the borrowing cost leaps higher than that, the arithmetic changes. Now the prospective equity holder needs to make 10 per cent, or 12, to justify the investment. So the price must drop.

What's happened since March is the reversal of that process. The post-Lehman hysteria died down, and for higher-rated companies at least – i.e., not you, Air Canada – the cost of borrowing has plunged again. It's not quite back to where it was in 2007, but it's creeping much closer.

That's what's driving the summertime stock rally: cheaper and cheaper money.

But common sense tells you that game will only last for so long.