Has the Market Gotten Ahead of the Recovery?

Moderation in all things is usually a good thing, but our pundits see too much of it in the nascent economic recovery -- and not enough of it among equity investors.

Stocks closed out July with their best performance for that month since 1989, as the Dow Jones Industrial Average gained more than 700 points. Although the recession is ebbing, many earnings reports showed strength and recent economic data allowed for some optimism, bearish market watchers weren't ready to bet the ranch on recovery.

"While we are past the most pronounced part of the downturn, it may still be premature to call for the end of the recession merely because of the prospect of a positive third-quarter GDP result," Gluskin Sheff chief economist David Rosenberg wrote on Friday. "And even if the recession is ending, as we saw in 2002, that does not guarantee a durable rally in risk assets. Sustainability is the key, and it remains the wild card."

Morgan Keegan economist Donald Ratajczak said that the spate of positive earnings news -- with about 40% of the S&P index's names reporting, earning per share were up about 11% from the year ago quarter -- would be tough to replicate. Most gains came from cost cutting, not organic growth, and that has its limits, Ratajczak warned.

"Unfortunately, those favorable profit margins are caused by the elimination of marginal activities," the economist wrote July 27. "This provides a one-time enhancement to margins and productivity that will not be sustained even as surprised analysts will begin to think that it will."

Ed Yardeni, founder of Yardeni Research, notes that good earnings news -- even if it’s only due to cost cuts -- is welcome indeed, since those measures have had the intended effects.

"Businesses always cut costs during recessions in an effort to maintain profitability when their sales are weakening," he wrote July 27. "This sets the stage for higher profit margins and profits when revenues stage a cyclical recovery. In other words, it’s not different this time. It will be different only if the economy and sales don’t recover. The stock market discounts the future, and it is predicting that better-than-expected earnings now will be followed by a recovery in revenues, and more positive earnings surprises."

But for a real recovery to take hold, people need to go back to work. Pimco's Bill Gross warns that getting them there will be a "Herculean task," even if the four-week average of jobless claims is shrinking.

"Common sense tells us that consumer spending growth comes from highly employed, well-compensated labor, and we are far, far from even approaching that elemental condition," he wrote in his August investment outlook. "The fact is that near double-digit unemployment has resulted from numerous business models that are now broken: autos, home construction, commercial real estate development, finance, and retail sales."

The global research desk at Societe Generale wasn't quite as harsh in assessing the Thursday conclusions of the Fed's Beige Book, but it still offered a tempered view that's appropriate for a modest, uneven recovery.

"The Beige Book rarely alters the economic outlook, but anecdotal stories do add color to the data," the report said. "In the latest report, the pace of declines in economic activity has moderated even though levels remain weak. The two major areas of improvement include manufacturing and residential real estate. On the downside, consumption and employment conditions are still reported as being very weak."

The situation remains firmly on the "less bad" side of the economic equation, but every positive earnings result inches closer to genuine good news.