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Market Rally Appears to Have Legs

Are we there yet?

Yep, it's that annoying question often heard from the backseat of your car on a long road trip. But when discussing the prospects of a recovery in the U.S. economy, answering, "We're almost there," may not be stretching the truth this time.

Major stock market indices are at their highest levels in more than a year thanks to a robust post-war rally and improving sentiment among investors. The Dow Jones Industrial Average is up 27.2% since March 11 while the Nasdaq Composite Index has posted a 45.7% gain during that time frame. This year, the average domestic equity mutual fund is sporting a 21.5% gain through last Thursday, according to Chicago-based fund tracking firm Morningstar.

Further underpinning the road to recovery is the recent spate of encouraging economic data that has come through the pipeline. "With each passing week, as we get more and more economic statistics coming out, the picture seems to get a little bit brighter," said Robert Brown, chief investment officer and senior vice president at GE Capital of Stamford, Conn. Brown also oversees the firm's $2 billion separately managed account unit, GE Private Asset Management.

In fact, 14 out of the last 19 government reports to hit the Street have matched or exceeded economists' forecasts. Earlier this month, the Commerce Department revised upward its second-quarter gross domestic product number, saying that the U.S. economy grew at a 3.1% clip, which served to buoy investor sentiment. The number blew past the preliminary forecast of 2.4% growth and came in well ahead of the 1.4% rise it posted in the first three months of the year.

Specifically, the manufacturing sector is showing signs of improvement, according to the latest report from the Institute for Supply Management. The agency's purchasing managers' index, the single best gauge of factory sector conditions, rose to 54.7 in August from 51.8 in July, marking its fifth consecutive monthly gain. Typically, any reading above 50 signals expansion in manufacturing activity.

"Things are improving not only in terms of macroeconomic indications, but corporate earnings are also slowly turning the corner. From that standpoint, we're feeling extremely optimistic," Brown said.

Meanwhile, the Federal Reserve issued the results of its beige book survey last week, saying that the economy continued to improve in the summer months, as 11 of its 12 districts reported a ramp-up in business activity. The anecdotal survey found that manufacturing labor demand appears to be firming and that layoffs are becoming less frequent. Still, there has not been a significant pickup in hiring or wages, the Fed noted.

"Labor markets remain slack across the nation, with few reports of occupational shortages," it said.

But the employment data is a lagging economic indicator that tends to improve at the very last stage of recovery, according to GE's Brown. "Job cuts are down, help-wanted ads are up and initial jobless claims are improving," Brown said. "It may be that the job situation has also reached a turning point at this time, but I think it's in sync with the kind of recovery we're having and is not a disturbing element."

Neil Hennessey, president and portfolio manager at San Francisco-based Hennessey Funds, strongly believes that we are in the midst of a recovery and that the market will continue to flourish. Based on the market's behavior after past military conflicts, prices are bound to head higher, he said. He compared the current market to the periods that followed World War II, the Korean War, the Vietnam conflict and the first Gulf War .

The market normally retracts 15% of its value when a conflict begins and then during the conflict, it will come back to break-even, he said. At the end of a conflict, it will actually end up finishing in positive territory, and then the market grows approximately 11% a year until the next conflict. Indeed, the market fell 15% from Dec. 1 to March 11, right on the nose. Then the market made a strong push to the upside, making up all the ground it lost, and more. "History tends to repeat itself," he said. Hennessey sees the Dow eclipsing 10,000 by year's end.

Messy Recoveries'

Some investment professionals had a more measured response to the recovery question. "Corporate earnings should be strong in the second half," said Keith Keenan, vice president of institutional trading and a partner at New York brokerage Wall Street Access. "But, I am not confident that technology earnings are achievable in the second half. Tech stocks are discounting an extremely smooth recovery. Recoveries are usually messy. I anticipate some significant bumps in the road." Keenan pointed to strong consumer sentiment and expanding business investment as the keys to a durable recovery.

"From the looks of it, we are experiencing a nascent recovery," said Seth Scholar senior research analyst at Sand Hill Advisors, an investment management company for high-net-worth individuals headquartered in Palo Alto, Calif. "However, it's too soon to say whether the downward trending of the bond market is going to weaken the tentative recovery we're seeing now."

Scholar noted that there has been a huge shift toward cyclical stocks in the market. He believes that cyclicals should do well in a recovery scenario, but that there are some questions as to whether some of them have gotten ahead of themselves in valuation, particularly among technology issues.

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