The Dow is rising, but robust U.S. growth is not here: what's going on?

By Money Matters Editors

Some investors, particularly those new to investing in stocks, are bewildered by the U.S. stock market’s ability to rise, even while the U.S. economy is still in recession, with high unemployment.

The reason has to do with how institutional investors – the players who move the market - operate. Institutional investors (IIs) are always looking ahead, or ‘down the field,’ to borrow a U.S. football analogy.

Typically, IIs are reviewing currently data, compare it to forecasts, then they make an assessment of the condition they think the economy will be 6-9 months into the future. If they believe economic conditions will improve, and corporate revenue and earnings will rise, they bid stocks up, and the market rises; worse, they sell stocks, and the market declines.




The Dow: a leading economic indicator

In other words, the Dow is a leading indicator: it’s a reflection not of current economic conditions, but what IIs think economic conditions will be 6-9 months ahead. And that’s why one can have the Dow rise 1,000 or even 2,000 points before the economic recovery takes hold and typical investors see manifestations of the better times in higher corporate revenue and earnings.

That’s what occurred during the Dow’s spring/summer rally, when it rose from about 6,500 to about 9,600 today, in early September. Based on an evaluation of economic data and other metrics, IIs believe the U.S. economy will be in recovery – in better shape – in March 2010 or June 2010 than it is today, and they’ve bid up prices.

Do the IIs always get it right? No, sometimes unpredictable events intervene, and some times they just get it wrong. But more often than not, IIs are correct, and if you, the typical investor, wants to profit along with them, you have to be in stocks when they are adding to their positions. As the Street adage goes, 'No one ever made a dime investing in stocks by waiting until conditions were 99% safe.' If you wait until then, almost all stocks will have been bid-up in price, and there will be few bargains.

Hence, the time to invest in stocks is now, if one expects to earn outsized gains during the next economic expansion. Establish or incrementally add to positions in quality companies.

(Money Matters will begin publishing Stock Reviews on Monday, September 14, 2009.)