Hope can fuel bulls' charge as stocks rally despite worries

As all burned investors now know, an economy mired in a deep recession acts like a powerful depressant on the stock market.

But there is an antidepressant with the power to fix this financial mood disorder: an economy showing signs of recovery.

The transition from recession to recovery has historically been a good time to own stocks, as the prospect of better days ahead gives investors a reason to buy. Big rallies occur even though many economic worries still persist, the buying is built largely on hope, and skeptics loudly proclaim that the gains can't last.

The broad U.S. stock market's quick and powerful 50% rally since hitting a 12-year low in early March is proof that this market phenomenon remains in vogue.

"In the beginning of bull markets, investors focus on faith more than fundamentals, sounding more like (evangelist) Billy Graham than (famed value investor) Benjamin Graham," explains Sam Stovall, chief investment strategist at Standard & Poor's.

But that faith has been tested in recent days — leading many investors to wonder if it's too late to get in. The latest readings on consumer confidence, retail sales and profits at home-improvement retailer Lowe's came in weak, reminding investors that consumers — a key driver to a sustainable recovery — are still not in a spending mood as the fallout of the worst recession since the 1930s drags on. A two-day stock decline of 3.3% before Tuesday's 1.0% rebound increased calls for a pullback from analysts who say stocks have shot up too far, too fast, given the still-weak business environment. "Headwinds Developing" was the title of a report out Monday from Bruce Bittles, chief investment strategist at R.W. Baird.

Still, buying stocks on faith, while not risk-free, is not altogether irrational, since stock prices are built on the future, not the past. The stock market is viewed as an economic forecasting tool. Since 1984, the market has been right 80% of the time in calling the economy, Ned Davis Research says. Investors hope stocks have correctly called the end of this recession.

"Investors are anticipators," adds Stovall. "They can't wait for the data to confirm their assumptions (that the economy is getting better), because they are competing with millions of investors around the globe. They want to get in before the others."

But even Stovall won't rule out a pullback in the short term as mixed economic data raise questions about the strength and staying power of the recovery. The biggest stock dip so far has been a 7% swoon from mid-June to mid-July.

It often pays to invest when the financial system and economy appear on the verge of collapse and stocks are selling cheaply — as was the case in March, when even President Obama was warning of the possibility of a depression.

"We have found you make more money when you go from horrible to bad than from good to great," says David Darst, chief investment strategist at Morgan StanleySmith Barney.

History backs up that claim. A Citigroup study shows that stocks start rising in the second half of recessions, gaining 13% on average since the early 1950s. Citi data also show that stocks post average gains of roughly 40% in the 12 months after a market trough. Stocks also fare well once a recession ends, says Ned Davis Research. Stocks were up sharply one year later in nine of the past 10 recessions.

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