Sucker's rally

Andy Kessler, a former hedge fund manager turned writer, says in the WSJ that the recent stock market run was a "Sucker's rally".  Of course, with 20/20 hindsight over the past couple of days this appears to be a correct assessment.  

Stock markets do not always reflect the fundamentals of the economy.  Just because the Dow goes from 6500 to 8000 doesn't mean the economy is all better now.  Jobs are still being lost in the hundreds of thousands every month.  Fundamentals haven't shifted, perceptions have.  Instead of proselytizing doomsday, investors have jumped on the bandwagon of rising stocks expecting to ride the wave back to 14,000.  Such expectations are misguided.  An handy rule of thumb is to watch the forecast Price to Earings (P/E) ratio.  Although forecast earnings may be an inaccurate gauge of performance, historical earnings may be even less accurate.  Many forcast P/E ratios were recently trading around 15, which indicates that investors are willing to pay 15 times what they expect shares a firm to earn in the next year in order to own its stock.  For many "value" companies, that is an aggressively high price.  A more reasonable level would be something like 10 or 12, or even less if earnings are uncertain (like they are now).  

Another important consideration not mentioned in the article is the newly enacted regulation restricting short selling.  After the rampant "naked" short selling that constributed to the collapse of banks like Bear and Lehman, regulators have sought more ways to prevent pessimists from betting against the stock market.  Surely many investors would happily short sell shares but are unable to do so.  This will keep prices at an inflated level for longer.  This recession has a long way to go before it's over, and cautious investors should be aware of the risks ahead.