Why did the American stock market fly to the moon on Wednesday?
First, this is a market that has said over and over again that it wants to go up. That sort of sentiment is not to be sneezed at. On the other hand, that sort of sentiment might make some contrarians highly suspicious.
Second, the Fed, the Bank of England, the ECB and other central banks announced a new program to provide liquidity to the world’s banks (primarily meaning European banks). The liquidity facility is supposed to go only to solvent banks, but students of American banking history will quickly recognize that the two largest (percentage-wise) lending programs to American banks were Franklin National and Continental Illinois, both distinctly insolvent banks. We also have the 2008-2009 experience of Fed lending to Bank of America (NYSE:BAC) and Citi (NYSE:C) that were, but for Government intervention, insolvent. Therefore we are doubly suspicious this time around.
Third, if the European banks go down—or even if they require funding from their government paymasters—the European economy is in even worse trouble than it is now. So the relief that the central banks are going to go into the tank is palpable.
Fourth, consumer confidence is said to be on the rise, despite all sorts of economic indicia that suggest that the global economy is in a parlous state.
As investors, what are we to make of this situation? Markets have been known to perform well for specious reasons for considerable periods of time. And something may come along that will validate the market’s performance to the upside.
I prefer to look at the medium-term possibilities and likelihoods. Europe is not going to solve its problems any time soon. That will overhang global stock markets for many months, if not years. Forecasts of doom may be overblown, but the crisis atmosphere in Europe is likely to continue because the ECB and IMF have to keep the pressure on, while at the same time they let a little steam out of the system so it does not explode.
The U.S. economy is still at the mercy of European sovereign debt and banks and the U.S. real estate market. None of these factors is likely to improve very much in the near term.
So what of corporate profits? They are still robust, which is a good thing. But the market pays, ultimately, for what it thinks will happen tomorrow. Today there is euphoria about government-supported liquidity. Loss of liquidity is the end of the line—bankruptcy. But loss of liquidity only occurs when the market believes that the entity, be it a bank, a business corporation or a country, may have no equity capital left. If you want to know the future of the stock market, you must evaluate how investors will evaluate bank, business and sovereign capital positions over the next six months.
One swallow does not a summer make, they used to say.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.