Dow jumps, but recession continues: what's going on here?

By Money Matters Editors

Some investors, particularly those new to investing in stocks, are bewildered by the stock market’s ability to rise, even while the 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, comparing 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 lead 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 it in higher revenue and earnings.

That’s what occurred during the Dow’s spring/summer rally, when it rose from about 6,500 to about 9,683 Tuesday, in mid-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 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. 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. Incrementally add to positions of quality companies and establish new positions in the same where you haven’t previously.