Dow turns positive for the year as investors bet on recovery

NEW YORK -- The black-and-blue Dow blue chips are finally back in the black for the year. Will they stay there?

On March 9, the Dow Jones industrial average was in free fall, awash in a pool of red ink. Investors' imaginations mirrored the bleak performance by conjuring up scary images of the iconic stock index tumbling to zero.

Since then, the Dow — and the entire U.S. stock market — has basically shot up in a straight line. Stocks have risen at the fastest clip in the first 90 days after a bear market bottom since the Depression-era 1930s.

The Dow's 34.4% rally off its March 9 low erases the deep hole it dug for itself earlier in 2009 and puts it back in positive territory for the first time since early January. The Dow, up 23 points this year at 8799 but down 37.9% from its all-time high, is the last major U.S. stock index to turn positive for '09.

"We went from meltdown to melt-up," says Ed Yardeni, chief investment strategist at Yardeni Research.

What changed? The get-me-out-of-this-market trade that was in place all the way down — which Wall Street calls the "Depression II" or "Armageddon" trade — was abandoned as fears of a worst-case economic outcome faded. The government's ability to stabilize the economy and banking system has reduced record fear levels, setting the stage for a revival in risk taking.

Wall Street has put on a new, more optimistic trade, dubbed the "Recovery Trade." It's a bet on an economic rebound. Its success has been driven in large part by the "green shoots" concept. This term was coined by Federal Reserve Chairman Ben Bernanke to describe the early signs of a recovery that are gleaned from economic data that come in less bad than expected and point to better days ahead.

In recent weeks, a slew of less-gruesome-than-expected data have come in, fueling optimism in the green-shoots theory.

The latest readings on consumer confidence, retail sales, job losses, unemployment claims, pending home sales, car sales, personal income, construction spending and manufacturing topped expectations.

The ability of the 19 major banks to survive the government's "stress test" in May and successfully raise needed capital from private investors has also boosted confidence.

Still, stocks have recently been in stall mode, trading mainly sideways as investors determine their next move.

Where do stocks go from here? What's the next winning trade that will turn the big bounce into a sustainable bull market? What could go wrong?

The Standard & Poor's 500 index is up 40% since March 9, a megajump that can be interpreted negatively or positively.

On the bullish side, the current gain off the low is below the 55% average rise in the past five recessions, data from Navellier funds show. This underperformance suggests more upside. On the bearish side is the fact that the Dow enjoyed five rallies ranging from 23% to 48% in the period following the 1929 stock crash and through the ultimate 89.2% drop ending in 1932. This suggests that another down leg can't be ruled out, nor can a longer period in which sharp rallies are followed by swoons.

History teaches us …

The stock market's big rally off very depressed levels (the S&P 500 plunged 57% in the bear market) closely follows the textbook behavior of stocks, which historically have started rising four to six months before the end of a recession. The market acts as a forecasting tool, pricing in future events in real time.

The bottom line is, if the current stock surge is to turn out to be more than a fleeting bounce, the green shoots that investors have been cheering must translate into real growth and corporate profits, not turn into weeds. Hopes for a lasting economic recovery must become a reality. And the current recession, which began in December 2007, must end soon.

Rising stock prices reflect a belief that the economy will start growing in the second half of the year, most likely in the fourth quarter. Jim Swanson, chief investment strategist at MFS, targets Thanksgiving Day as the likely end of the recession. "It looks like we got a Great Recession, not another Great Depression," Swanson says.

While few economists are betting on a V-shaped recovery, or a sharp rebound, as is customary after recessions, investors will at least want to see a "smaller V-shaped" trajectory to make the case for a sustainable rally.

Working in favor of the bullish case is that this rally has been greeted with skepticism from the start, notes Bill Stone, of PNC Financial Services Group, author of a report titled "No True Believers." The report notes that stocks have historically gone up when investor optimism is muted.

Old-fashioned momentum could also help the rally last longer than skeptics believe possible. It's not uncommon for money managers who have missed out on gains because they've been on the sidelines to jump back in to boost returns and try to keep pace with competitors.

This could lead to a "buying panic" and push prices even higher, Bob Dickey, analyst at RBC Wealth Management, said in a note to clients.

Pent-up buying power and lots of free cash could also play a factor in keeping the melt-up rally phase intact.

There's growing evidence that institutional investors, such as pension funds and hedge funds, are "underinvested" in stocks. A recent Merrill Lynch survey found that professional money managers are getting increasingly bullish, but are holding smaller allocations of stocks than their charters allow, a situation that could resolve itself by them adding to their stock holdings. Many have been caught out of position and might have to chase returns.

"That's a lot of (potential) buying power," says Mike O'Rourke, chief market strategist at BTIG.

Under the mattress

There's also no shortage of cash held by individual investors. There is $9.6 trillion in cash deposited in stable, low-yielding investments such as money market funds, certificates of deposit and savings accounts, according to the Investment Company Institute and the Federal Reserve. Cash levels are at or near records.

O'Rourke says the $3.8 trillion parked in money markets amounts to more than 45% of the current market cap of the S&P 500-stock index. An analysis by Harris Private Bank found that whenever cash on the sidelines creeps above 25% of the stock market's value, stocks tend to rally in the next 24 months as cash filters in. O'Rourke estimates that $500 billion in cash that was stashed safely away during the current financial crisis could find its way back into stocks.

If stocks continue to fare well, the puny 0% to 1% yields offered by safer assets may prove to be inadequate for investors in search of fatter returns. An argument can be made that both a psychological and portfolio shift toward riskier assets such as stocks could occur, generating more demand.

Signs of greater risk tolerance are already evident in the behavior of mutual fund investors, as well as the strong recent performance of higher-risk assets, such as commodities and emerging market stocks, assets that benefit most from an economic recovery.

Net flows to stock mutual funds have risen nine-straight weeks, after net outflows in nine of the previous 10 months ending in March, according to the ICI.

Another clue that points to a healthier market is that stocks from an ever-widening circle of industry groups are rising. Since the March 9 low, all 10 S&P 500 sectors have enjoyed double-digit percentage gains.

The market's also flashing positive technical signs. Stock indexes are rising above long-term trend lines. These breakouts are often seen as signs that the trend is up and are used as entry points by investors. "People watching this stuff will view it as a good sign, and it could add buying interest," says Jack Ablin, chief investment officer at Harris Private Bank.

Despite all the potential positive market drivers queuing up in the pipeline, there's no shortage of things that could derail the rally-and-recovery-trade thesis.

The biggest risk is if the hoped-for economic recovery fails to materialize. Some economists warn that the recovery might come in less bullish shapes: an L-shaped recovery means the economy stabilizes but doesn't really grow; a W-type rebound suggests the economy is at risk of a double-dip scenario, in which growth resumes only to falter again; and a U-shaped recovery would mean a muted period, in which the economy bounces unspectacularly along the bottom for a long time. All these slow- or no-growth scenarios would act as serious headwinds for stocks.

And after the massive spring rally, stocks are no longer selling at bargain-basement prices. Based on its profit projections for next year, Strategas Research Partners says the S&P 500's fair market value is about 900, which is below Friday's close of 946. That prompted the firm to "reclassify valuation as a market liability." Still, the market is trading at 12.7 times estimated profits for 2010, says Thomson Reuters; that's below the average price-to-earnings ratio of 15.

Other risk factors

Another major risk is if all the money the government has thrown at the financial crisis results in higher interest rates, runaway inflation or a mushrooming budget deficit that's increasingly expensive to fund.

The yield on the 10-year Treasury note rose as high as 4% last week, a seven-month peak. The key centerpiece of the government's plan to resuscitate the economy is based on low interest rates, which cut borrowing costs for cash-strapped consumers on things such as mortgages.

Rates on 30-year fixed-rate mortgages last week jumped to 5.59%, their highest since late November, according to Freddie Mac. Mortgage applications have declined sharply. The rate increase hurts home affordability.

Rising rates, coupled with the potential of a protracted period of unemployment, could unleash a second wave of financial pain on banks, as they're forced to deal with a new wave of consumers who can't pay their bills.

"These huge job losses seem to be weed-whacking the green shoots" story, says TrimTabs CEO Charles Biderman. The rise in oil above $70 a barrel (its price is up more than 60% this year) could be a drag on the economy by hurting consumer spending.

Wall Street is also girding for a long period of consumer sobriety, says Woody Dorsey, an expert in behavioral finance. The fear is that people will spend less and save more, a change in behavior that will slow the growth of corporate earnings and keep a lid on stock prices for years.