Stock rally defies fears of a slumping economy

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Say what you want about Europe's economic mess, slow employment growth in the United States and persistent concerns about a slowdown in China. The stock market has taken a far sunnier view.

The benchmark S&P 500 on Tuesday touched its highest level in more than four years, raising excitement that the bull market in stocks is back on track – but also renewing concerns that investors may be setting themselves up for disappointment should good news not prevail in the months ahead.

The day's action reflected a bit of both moods. The S&P 500 rose as high as 1,426.68 before falling back in afternoon trading, marking its highest intraday level since May, 2008, before the worst of the financial crisis pummelled stock markets.

It ended the day at 1,413.17, down 0.4 per cent.

But the moves nevertheless cap an extraordinary summer in which major stock market indexes have shrugged off weighty concerns about the global economy and rallied over the past three months, skewering the old saw that it is best to sell in May and go away. Since the start of June, the S&P 500 has surged, while Canada's S&P/TSX composite index has gained 6.7 per cent.

"The market is focused on: Europe is not going to fall apart, we're going to have some sort of sustainable recovery in the global economy and the U.S. economy, and stocks are trading very cheap," said Paul Taylor of BMO Asset Management.

Despite the summer rally, Canada's benchmark index remains about 15 per cent below its recent high point in 2011, largely because resource producers have been struggling with lower commodity prices over the past year.

The summer's gains have come amid signs that some of the biggest stresses on the global economy could be easing.

There is hope that Europe is making progress in dealing with its crippling debt crisis, with policy makers sending signals that they will do everything they can to avoid a systemic failure.

Earlier this month, the U.S. economy provided a few hints that it is improving after posting sluggish growth in the first half of the year. The number of job gains handily beat expectations in July and the depressed housing market has been showing signs of life.

Over all, though, this is hardly an upbeat environment for investors, given the number of uncertainties in the world: Europe appears to be stuck in a debilitating recession, the euro could die as a common currency, and the U.S. faces a year-end "fiscal cliff" of tax increases and spending cuts.

Some hopes are pinned on the U.S. Federal Reserve rescuing the U.S. economy with an aggressive stimulus package – but any rescue attempt merely underlines the gravity of the situation.

That is is why the stock market's gains have been met with so much skepticism.

A recent survey of investor sentiment by the American Association of Independent Investors showed that the level of bullishness among small investors has improved to about 37 per cent in mid-August,. That is well below a high of nearly 50 per cent at the start of the year.

Ed Yardeni, chief investment strategist of Yardeni Research, counts himself as a bullish observer because of rising corporate earnings in recent years. Yet even he believes the bull market could be running on fumes.

"Based on the performance of forward earnings over the past year, this bull market is aging," he said in a note to clients. "While I'll be happy if my year-end S&P 500 target of 1,450 is surpassed in coming months, it's getting harder to see much more near-term upside."

Particularly bearish observers cannot see any upside, and argue that the rally of the past three months could make what follows even more painful.

John Hussman of Hussman Funds wrote in his recent note to clients that the world is quietly sliding into a global recession, leaving stocks looking vulnerable to a setback.

But the key is whether upbeat economic news can back up what the stock market is now implying.

"We've seen some mending of economic data from the very weak second quarter," Mr. Taylor said. "If we get further validation, the market should move higher."