The stock picker’s dilemma

We have enjoyed a significant stock-market rally over the past few months. Since reaching its low in early March, the S&P index has increased approximately 25%; the NASDAQ has been up an even bouncier 31%. This is surely good news for investors – at least, the ones that stuck around.

There are also signs, however, that this rally is not indicative of a lasting bull market. Frankly, nothing in the economic data suggests that the rally can hold. Indeed, the rally has all the signs of a classic bear-market rally, that is, a short rally falling within a longer secular bear market. If this is correct, then the environment for stock pickers over the summer will be as tough as it was back in fall of 2008, although it might not seem as bad because the losses will be less severe and come more slowly. But they will come all the same.

When the declines in stock values pick up pace again – and this week might mark its beginning – will there be any safe haven for investors?

Back in the first quarter, I had thought that cash-cow consumer products companies – like Procter & Gamble and Johnson & Johnson – were winning propositions, but I learned the hard way that earnings alone are not enough in this environment. The market had decided that the high premium placed on those stocks was too high. Instead of investors flocking to the relative safety of these stocks, the values of these companies has dropped – P&G is down 14% since New Year’s Day; J&J is down 8.5%. The S&P index itself is about even. I would have never guessed that a market index could outperform these two companies in the first quarter, but there it is.

So if the banking industry is still too sick to lend, unemployment is still rising, levels of new business investment is still low, earnings reports are still low, and international trade has tanked, why exactly are stocks rising?

Even worse for stock pickers, an end of the recession will not necessarily mean a recovery. We could in theory find the bottom of the market and then get mired at or near it, thanks to a combination of negative indicators, such as excessive levels of government debt, inadequate demand, high taxes, or what have you. The latest Wall Street Journal survey of leading economists reveal that more and more folks feel this scenario is a distinct possibility.

In this case it is hard to see how a stock picker can beat the market at large. Who, for example, could have seen the performance of Sears Holdings coming back in January, when consumers delivered a perfectly dismal Christmas shopping season. Yet, just today, SHLD traded 10% to 20% higher today on outstanding earnings of 21 cents per share. The Street was expecting losses. Finding those positive earnings surprises is no easy feat.