Why the stock market rally won't lastMarch 1, 2012: 11:14 AM ET
With no signs the Fed will launch another round of bond purchases and with corporate profits expected to slow, the party won't last for U.S. equities.
FORTUNE -- Wall Street's bull market reached a few milestones this week: The S&P 500 index closed at double its bear market low from 2009. The Russell 2000 small-stock index closed at a new all-time high, erasing all of its 2008-2009 bear-market losses. And the tech-dominated Nasdaq composite index rose to its highest point in a decade.
It's easy to attribute the rally to the slew of cheery economic data. But what's really driving the bulls has more to do with investors frustrated with virtually zero returns on cash.
True, the market rallied Wednesday amid news that the European Central Bank – in efforts to keep debt-troubled Europe from slipping into a credit crunch – would offer banks ultra-low interest loans. Stocks also rose as the Commerce Department reported that the U.S. economy grew faster than originally thought at the end of 2011. What's more, the U.S. Labor Department reported last week that the four-week average of applications for Americans seeking unemployment aid fell to its lowest point in four years.
Such factors might be the grease on the wheels driving investors into stocks. However, the gains also come as investors find themselves with few places to get decent returns. As Mark Freeman, chief investment officer of Westwood Holdings Group (WHG), points out, the cost of borrowing is as low as it has ever been. Effectively, the flight to safety means investors are paying to lend money to the government.
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For each of the past five years, the average rates that the government pays on in its debt have declined -- from 4.92% at the end of 2006 to 2.24% at the end of 2011. Rates have fallen further so far this year. With inflation running around 2%, that puts real returns on cash in negative territory, Freeman says.
He sees the stock rally this way: "What has changed at the margin is that confidence has improved some," he says. "Investors are now saying, 'Hey, I am still getting negative returns on cash and things seem to be doing a little bit better. So maybe I'll invest in something riskier."
And that's generally what the Federal Reserve had in mind when it launched two rounds of bond purchases – the latest in September under what's called "Operation Twist," which promised cheap and easy money by driving down long-term interest rates. In a February research note, Westwood noted that dividends are beginning to grow again as cash at the biggest corporations piles up. Total dividends paid out by S&P 500 companies rose from $196 billion in 2009 to $241 billion in 2011. In 2012, dividends are expected to be a record $275 billion.
Indeed, the Fed's easy money policy has helped prop up, if not stabilize, the market thus far. But it's going to be tougher for the stock market rally to continue. So far, the Fed has not signaled any signs it will launch another round of bond purchases. Without the sweet icing – if you will – the cake is left bare with only its basic ingredients. That is, the fundamental strengths of the economy.
If you believe that corporate profits largely drive the performance of the stock market, then it's likely that the good times in equities could come to a halt this year. Earnings for the S&P 500 are expected to rise just 6% this year, down from 16% in 2011, according to S&P Capital IQ. And profits have already shown signs of a slowdown, growing just 8% in the fourth quarter of 2011 compared with the same period in 2010.
Indeed, Fed Chairman Ben Bernanke on Wednesday offered a tempered view of the U.S. economy. The housing market remains a drag, while the job market has been "far from normal," he says. All the while, rising gas prices threaten consumers' buying power.
The Fed predicts the economy will grow only 2.2% to 2.7% this year, only slightly faster than it grew in the second half of 2011. Admittedly, Bernanke has been outrageously wrong before but it would only be fair for us to question if the basic ingredients that make a strong economy could, in the end, really prop up the stock market on its own.