Are Investors Losing Faith in the So-Called "Recovery"?

For the first time in eight trading days, the Dow Jones Industrial Average produced a plus sign – up 57 points to 9,744. The last time the Dow achieved this increasingly rare feat was on June 23, when it gained five points to end the day at 10,298 – 554 points higher than yesterday’s close.

The Dow’s recent grim performance just goes to show that bad things sometimes happen to good stocks. On the other hand, good things sometimes happen to bad stocks. How else would one explain the stock market’s dazzling performance between March of 2009 and April of 2010?

During that magical 13-month span, the Dow soared 77% from trough to peak. But bad stocks performed even better. Many homebuilding stocks doubled, while many of the shakiest stocks in the shaky financial sector tripled, quadrupled or quintupled!

Perhaps these low-quality high-fliers deserved their mark-ups from the panic lows of early 2009. Or maybe they were just bad stocks that happened to be in the right place at the right time – the right place being the US stock market after a panic washout; the right time being the moment in which most investors believed the Federal Reserve had created an economic recovery out of thin air.

But perceptions are changing. Both good stocks and bad stocks are in the wrong place at the wrong time.

After the recent spate of disappointing economic news, the Fed’s magic touch is attracting suspicion and skepticism. Did the Fed really pull a recovery out of thin air? Or did the Fed merely engage in some sort of monetary sleight-of-hand?

Whatever the case, investors are feeling duped…and heading for the exits. The stock market is falling…and economically sensitive stocks are leading the way. With the S&P 500 Index down 15% since late April, the ISE Homebuilders Index is down a hefty 36%. Many financial stocks are also down large double digits from their April highs.

Therefore, those readers who are taking notes at home may wish to highlight the following observations:

1) US stocks are down a whole bunch.
2) Economically sensitive stocks are down even more, which is not an encouraging sign.

But don’t put the notepads away just yet. Please note one additional curiosity: Emerging Market stocks are advancing, even while US stocks are falling.

Stock Market Returns

This unusual divergence may not mean anything in particular. But it may not mean nothing. Usually, “risky” stocks track one another, at least during periods of high volatility. Amidst the crisis conditions of late 2008, for example, Emerging Market stocks tumbled tick-for-tick with US financial stocks and other risky sectors of the US stock market.

But then a funny thing happened; Emerging Market stocks stopped falling. They reached their crisis lows in December, 2008, even though the S&P 500 did not bottom-out until three months later. Emerging Market stocks have been going their own way – more or less – ever since.

The Morgan Stanley Emerging Market Index has soared 66% since December 8, 2008. During the identical timeframe, however, the major indices of US financial stocks and US homebuilding stocks have produced losses…despite their spectacular rally in 2009. This substantial 18-month-long divergence between “risky” foreign stocks and “risky” US stocks makes the recent mini-divergence between these two groups all the more intriguing.

Once again, Emerging Market stocks are going their own way and ignoring the disappointing trends in the US economy and stock market. The recent divergence – modest as it has been – may not mean anything at all. But a forward-looking investor may be tempted to wonder if it does mean something.

Maybe the distinction between “Emerging” and “Developed” is blurring…or becoming completely irrelevant.

In other words, which is the true Emerging Market?

The North American superpower with:

1) Annual budget deficits above 10%;
2) Debt-to-GDP above 85% and;
3) Zero employment growth during the last 10 years.

Or the South American non-superpower with:

1) Annual budget surpluses (or very slight deficits);
2) Debt-to-GDP below 50% and;
3) Rapid employment growth during the last 10 years.

Let the reader decide. But before deciding, let the reader learn Portuguese.

Eric Fry
for The Daily Reckoning

The Daily Reckoning