Signs of Life

The U.S. economy grew at a 3.8% annual rate in the second quarter of 2007, the government reported today. This was a substantial increase from the 0.6% rate posted in the first quarter, causing some to feel a little more optimistic about avoiding recession. Unfortunately, the report does not reflect events from July 1 to the present, a period in which the housing market's downturn accelerated. Indeed, a separate report today showed that new home sales fell 8.3% in August, and the median sales price dropped by 7.5% from a year ago. This was the steepest plunge in housing prices since 1970.

Clearly, then, the housing sector has not yet hit bottom and may not do so for a long time. So why are stocks going up? The stock market appears to have accepted facts and is in the process of adjusting itself to a different environment. Financial services and consumer discretionary stocks are the losers in this scenario, along with the homebuilders themselves. Who wins? No one, really, except for the fact that the Fed's interest rate cuts have sparked inflation fears and a flight out of the dollar and into commodities and foreign markets. Hence we see major rallies in energy, gold, and emerging markets.

The stock market has been called a giant discounting mechanism. It values companies based not on their current condition, but on a consensus outlook for their future prospects. This year's reality matters less than next year's forecast. Whatever else is going on in the world, the market consensus appears to be that aggregate corporate profits will remain generally strong. There is a great deal of variation within the benchmarks because some companies and sectors are expected to do better than others. In the big picture, however, the prognosis looks a lot brighter than it did a few weeks ago. Hence we see the benchmarks moving back up toward their recent highs. Whether they will be able to break through is the next big test. The Nasdaq 100 is already above its July peak; the Dow and S&P 500 need to follow soon.