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.