From the president to market pundits, everyone is trying to convince investors that all signs are green and it's time to buy. At least some of the motivation behind these rosy pronouncements is the idea that an extended rally in stocks can take us right out of our economic problems. (To learn how to cope with an economic decline, read Recession: What Does It Mean To Investors?)

It's Not A Market Problem
Unlike the stock market crash of 1929 and the resulting great depression, this credit crisis didn't start or end in the stock market. At the bottom of this very unappetizing pile of bad news are the unrealistic valuations for homes. Government incentives for affordable housing led to a credit glut that, in turn, drove home prices unrealistically high. These mortgages were then packaged and sold into the market, becoming toxic waste as the system producing them collapsed.

The market can't magically create a floor in real estate prices or forestall foreclosures – in fact, it's not in the interest of the market to do so if it could. The sooner the real estate market hits a true bottom, the sooner many of these hard to price mortgage-backed securities (MBS) will have an accurate valuation. In all likelihood, many homes will have to come down near their replacement costs – that is the cost of building the same home from scratch.

This is akin to stripping a company of all but its book value to decide what it's actually worth.

A rally in the stock market isn't going to be able to put a value on the MBSs no matter how enthusiastic investors are. Any broad rallies now based on Citibank's monthly earnings (a far from standardized metric) or the president's talk with Hugo Chavez is probably going to be fleeting until the toxic waste of MBSs are priced out of the system.

Credit simply cannot flow freely while harmful assets are weighing down the books of financial companies. Any government-led efforts to change this will more than likely result in inflation, not resolution.

Diamonds in the Rough
This doesn't mean there is no hope for individual investors in this market. Although the financial sector is riddled with toxic assets, many other industries don't have direct exposure.

These companies are being punished by the economic downturn that the credit crises wrought and many will be well positioned for profit when the economy turns around. Right now it may be better for investors to stop thinking in broad market terms like indexes and look for tough companies that are profiting and expanding despite the economic woes.

The heart of the economy is production and the companies that continue to produce through bad times are in a much better position to increase production when things change. Many companies are unable to keep up production without bank credit but some companies can because of cash reserves, low debt levels, recession proof products, etc.

Fortunately for investors, these companies are being drowned out in the larger market noise and may be going cheap. (Find out what you can do to prepare and cope in tough economic times by checking out 7 Ways To Recession-Proof Your Life.)

When the toxic waste is finally priced to clear, credit will ease and the economy will recover. It will be the companies that struggled through the recession that will post the big earnings and lead a true market recovery instead of an overly optimistic rally. A true stock market rebound is an indicator of recovering economy, but it can't fix anything in and of itself.

Related Articles
  1. Economics

    Is a Recession Coming?

    In the space of a week, the VIX Index, a measure of market volatility, spiked from 13, suggesting extreme complacency, to over 50, evidencing total panic.
  2. Mutual Funds & ETFs

    Top 5 Bear Market Mutual Funds

    Discover five bear market mutual funds that investors can turn to for generating maximum capital appreciation during a bear market.
  3. Forex

    The Pros and Cons of a Fully Convertible Rupee

    Amid the rising economic power of India, the talks of making the Indian currency fully convertible are gaining momentum. We look at the pros and cons.
  4. Markets

    The Origins of the Chinese Stock Market Collapse

    Learn about some of the reasons for the volatility in the Chinese stock market, including expansion of margin lending and governmental support.
  5. Investing

    What’s Holding Back the U.S. Consumer

    Even as job growth has surged and gasoline prices have plunged, U.S. consumers are proving slow to respond and repair their overextended balance sheets.
  6. Economics

    A Look at Greece’s Messy Fiscal Policy

    Investigate the muddy fiscal policy, tax problems, and inability to institute austerity that created the Greek crises in 2010 and 2015.
  7. Technical Indicators

    Using Moving Averages To Trade The Volatility Index (VIX)

    VIX moving averages smooth out the natural choppiness of the indicator, letting traders and market timers access reliable sentiment and volatility data.
  8. Investing News

    The Brief: Where Is the Bottom?

    Where is the market going today after yesterday's bumpy ride?
  9. Professionals

    Tips for Helping Clients Though Market Corrections

    When the stock market sees a steep drop, clients are bound to get anxious. Here are some tips for talking them off the ledge.
  10. Investing

    Finding Value in the Selloff Rubble

    Globally and in the United States, stocks are now in correction mode, with the recent erosion in equities in emerging markets and Europe in a bear market.
RELATED TERMS
  1. Regional Asset Liquidation Agreement ...

    An agreement between an asset manager and the Federal Deposit ...
  2. The New Deal

    A series of domestic programs designed to help the United States ...
  3. Bear Closing

    Purchasing a security, currency, or commodity in order to close ...
  4. Accelerated Resolution Program ...

    A program designed to reduce the time and cost of resolving failed ...
  5. Agency Swap Program

    A form of securitization whereby single-family residential mortgages ...
  6. Maximum Drawdown (MDD)

    The maximum loss from a peak to a trough of a portfolio, before ...
RELATED FAQS
  1. How does the risk of investing in the industrial sector compare to the broader market?

    There is increased risk when investing in the industrial sector compared to the broader market due to high debt loads and ... Read Full Answer >>
  2. How can I hedge my portfolio to protect from a decline in the food and beverage sector?

    The food and beverage sector exhibits greater volatility than the broader market and tends to suffer larger-than-average ... Read Full Answer >>
  3. How attractive is the food and beverage sector for a growth investor?

    The food and beverage sector is attractive for a growth investor. The sector's high degree of volatility means it tends to ... Read Full Answer >>
  4. What techniques are most useful for hedging exposure to the insurance sector?

    Investing style determines the best hedging techniques for the insurance sector. This sector comprises three segments, two ... Read Full Answer >>
  5. What is the formula for calculating the receivables turnover ratio?

    To calculate a company's accounts receivable turnover ratio, start with the net receivable sales for a given time period, ... Read Full Answer >>
  6. How can I hedge my portfolio to protect from a decline in the retail sector?

    The retail sector provides growth investors with a great opportunity for better-than-average gains during periods of market ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!