The stock market has a powerful influence in the mind of the average investor. The belief that the market carries important information is deeply ingrained in our collective psyche. "Mr. Market" is supposed to have the power to predict the future, at least 6 months ahead. Allegedly it is a "giant discounting machine" that relentlessly incorporates information about the perspectives for the companies, and thus, the economy. Naturally this theory becomes more popular when the market goes up as we would like to think that things are always getting better. In my opinion, the evidence suggests that the stock market represents investor's beliefs and, thus, its predictions are often as flawed as those of its components.
The idea of the stock market as a leading indicator does have some economic logic. As the economy begins to pick up, the first people to notice are those running actual companies in the real economy. Thus, a company sees an improvement in their business, which may result in an increase in stock buybacks and/or dividends which, other things being equal, should drive up stock prices. Similarly, as investors find out about improving earnings they are, other things being equal, willing to pay higher prices for company shares.
In the days before 24 hour dedicated financial media and internet trading there was a reasonable lag before the general public would perceive a business improvement in, say, US Steel or General Motors. In those days we had to wait for the reports to make it into the Sunday business section of the local newspaper. On the other hand, not only do we now have instant reports on every sector of the global economy, but we also have dedicated pools of capital (still) who try to exploit every piece of information (true or false) instantly. In other words, like anything else in financial markets, the financial media and the internet have significantly leveled the information advantage that a well connected investor could have enjoyed before the early 80's. In addition, the more developed the market the smaller the advantage, so there is less informational advantage in large-cap US stocks than in small-cap African stocks.
This, of course, does not mean that people won't try to anticipate earnings and that real surprises in particular companies will not occur. However, the notion that the stock market "knows" that the economy is getting better is severely challenged by the facts. For example, what was the market predicting in the Fall of 2007 when it was making new highs after the Fed began cutting interest rates? It seems to me that the answer is that it was predicting a simple liquidity problem which is what the Fed, the investor community, and most market pundits believed at the time. The same can be said for the rally from "The Bear Stearns Lows" which was hailed by most Wall St. banks as the final climax of a crisis that was barely beginning.
The stock market is nothing but the weighted sum of the beliefs of a very large group of people. Although it is based on reality as the companies do exist and represent the real economy, the fact is that its fluctuations are driven at least as much by economics as by mass psychology. The majority of the pundits, however, only emphasize the former while completely ignoring the latter. That is why, among other reasons, we have bubbles. Stocks, like paper money, are worth what people think at the time and people's thoughts can fluctuate for many reasons. That is why we had companies trading for less than their cash value in the 30's and profitless dotcom companies trading for 1000 times future earnings in the 90's.
In my opinion, this time is no different. The stock market predicted a recovery before Obama arrived because people thought he would be better than Bush. Once we saw that the problem was big enough to overwhelm even a competent administration the market predicted a worse recession. Now that it is going up we are reminded by the financial media that things must be getting better because the market is rallying.
Forgive my skepticism, but even if the monthly job losses improve to -300,000, the fact is that the economy will not really get better until that number at least gets closer to zero (i.e. we stop losing jobs at an alarming rate). It may surprise many in Wall Street, but when people are unemployed they consume less. In case you didn't know, our economy was about 70% consumption in 2008. In other words, either the jobless claims number becomes positive at some point or the economy will not improve. In fact, it may get worse. The stock market may anticipate this but the facts will not change. Putting everyone back to work may not be a necessary condition for the economy to improve but expecting a recovery because we go from losing 700,000 jobs to, say, 500,000 is a nonsensical proposition posing as analysis.
So why do people buy stocks right now? Nobody really knows. I do know, however, that most of the daily moves in the market are driven by people who manage other people's money. That is, they either get paid whether they make or lose their clients money or they have an asymmetric risk-reward payment (they get paid a lot if they win but they do not return any money if they lose). These individuals may be more prone to believe than those who have to risk their OWN kid's college fund or their OWN retirement money. In addition, they have no problem talking their book publicly on CNBC which makes them look convincing.
In summary, the economy may or may not improve in the next 6 months. The stock market, however, has a very mixed record as an accurate predictor. One thing I am sure of, the portfolio managers and other pundits parading on CNBC don't know now as they did not know in 2007 and 2008 when they predicted similar recoveries (most did not even anticipate a recession). In any case, they all have a vested interest in convincing the rest of us that the rally is "for real." As I see it, the recent rally has more to do with a change in manager's psychology than with any improvement in the real economy. As we have seen in the past, that psychology can reverse quickly and they will not even admit they were wrong.