Is the Stock Market Rally an Illusion?

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Economist David Rosenberg earned his way onto Institutional Investor's All-America Research Team for the past four years by making smart market calls for clients at Merrill Lynch. Now the chief economist and strategist at Gluskin Sheff, a Toronto-based wealth-management firm, Rosenberg tells TIME contributing editor John Curran why he thinks this market rally is headed for trouble.

TIME: We've got a pretty good market rally; consumer confidence is up. What's not to like?
Rosenberg: There's absolutely nothing wrong with consumer confidence going up, but it's really a matter of watching what consumers are doing as opposed to what they're saying. If you take a look at the retail sales data over the past couple of months, it has moved back down. It looks like consumer spending, after a bit of an increase in the first quarter — mostly just bargain-hunting in January — is also relapsing in the second quarter. I'm not really seeing evidence in the actual economic data, as opposed to consumer surveys, that consumer purse strings are opening up. (Watch TIME's video of Peter Schiff trash-talking the markets.)

But the Index of Leading Economic Indicators is also pointing to better times ahead.
What's interesting is that almost half the increase in the leading indicators was from the stock market. So people look at the leading indicators and say, "I gotta buy stocks." And yet the stock market is one of the 10 leading indicators, so it almost becomes a self-perpetuating development. Here's another thing to know about the index of leading indicators: in the past, the upturn in this index precedes the economy's upturn by as much as 12 months. So maybe it's telling us the recession ends 12 months from now. It could be earlier. But equity markets, historically, tend to hit their low not 12 months before the recession ends but four or five months. (See 10 things to buy during the recession.)

O.K., so when will the economy improve?
There's no question that we are, if not in the third quarter, then the fourth quarter of this recession football game. But what sort of recovery are we going to get? That's an important question, because the history books tell us that a sustainable bull market in the aftermath of a recession traditionally requires 4% real growth in the economy and 20% growth in corporate profits. But I don't think we are headed for such a strong recovery.

Does that suggest a trading-range market as an anemic recovery unfolds?
Bingo. It will be a trading-range market characterized by volatility. It will be an environment that will benefit active investment managers as opposed to passive investors. If you are in the "buy and hold" mentality, this is not a market for you.

Is there a possibility of a return to March lows?
It's unclear to me as to whether or not we have to break below the March lows [6440 on the Dow], but I'd be very wary about chasing the stock market right now. We don't have many similar historical examples to look at, but in light of credit contractions and asset deflation, it should be understood that this is not a normal manufacturing-inventory recession. Nor was the 1930s. At that time, we bounced off July 1932 stock market lows, and three months later the market was up 70%. I can only imagine what the psychology was back then — "How can we have missed out on that rally?" Here's the kicker: if you missed out on that rally's first three months and you piled all of your money into the equity market because you were chasing performance, well, I hope those people knew how to trade the markets, because the stock market from the fall of 1932 to the end of 1941 was unchanged; the rally was all given back.

Point taken. So in a poor economy, where should investors be putting their money? What is likely to flourish?
I am still very leery of the financials or anything remotely connected to U.S. consumer discretionary activity. I think that we are in a new paradigm of frugality that is widespread geographically and across income strata. It's not a cyclical theme but a secular theme. I want to be situated in areas of the market that don't have a lot of cyclicality in terms of consumer spending — or capital spending, for that matter. I favor staples stocks (food, beverage companies, etc.) over consumer discretionary stocks (retailers, travel, etc.). Also, look to the traditional areas of the market that perform well in a weak economic environment — not necessarily recessionary, but weak — such as health care or utilities. But you need to be selective.

On cyclical stocks, it's time for caution. I think homebuilding activity in the U.S. is in secular decline; I think U.S. consumer spending is in secular decline due to a shortage of income. The only part of personal income in the United States that's growing is government benefits, whether it's food stamps, welfare or unemployment insurance. But organic income is going down at a record rate, especially wages and salaries. (See how Americans are cutting back.)

If it's going to be a rocky time for stocks, how about bonds?
Government bonds have a certain allure because they're super-safe. Then again, the yield is very low. For anybody that doesn't want to take on the risk in equities but also doesn't want to be in low-yielding government bonds, there is an alternative. Investment-grade corporate fixed-income securities, I think, are going to be a very good place to be, and arguably will be tops in total return for the next several years.

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