Can Stocks Still Rise if the Economy Stinks?

If the economy is still weak, why has the stock market risen over 30 percent since the March lows? It can be truly perplexing that while we're in the worst recession in 25 years and housing remains in a slump, stocks have actually gone up -- and not by a small amount. What gives?

What occurs in the economy impacts stock prices. But there's a missing piece: the stock market takes into account what is happening and what will happen, or at least what investors believe could occur in the future. So the economic numbers that you see as headlines today have likely already been factored into the price of stocks.

The trend works both ways. In March, stocks fell to the lows on the year because investors were concerned about the future -- "What if the stress tests show that banks are insolvent? How much more pressure can the financial system bear?" With all of the unknowns, investors sold stocks until additional information made the situation clearer.

In the weeks since the lows, we know that economic data has become "less bad" and that the government is willing to pump an ungodly amount of money into the system. In fact, stocks began a steep ascent at the very point when jobs were vaporizing and consumer confidence was in the tank.

The bullish theory posits that the bad news is pretty much all out there, and that every day something worse doesn't happen means brighter days ahead -- this is usually accompanied by some mention of "green shoots" or the like. The bear case is that the economic recovery has just begun and that no amount of wishing will get you over that hump. If the bears are right, then we are looking at something like Japan's lost decade, where bear market rallies ensnared many a bull.

During uncertain times, we often turn to experts like Warren Buffett or Alan Greenspan. Unfortunately, neither of these guys has been exactly prescient. At the 2008 Berkshire Hathaway annual stockholder meeting, the Oracle noted that much of the economic damage "has already been recognized." Oops -- just a year early on that call!

If you want to know how wrong Greenspan has been, just pick up a copy of Bill Fleckenstein's Greenspan's Bubbles. Besides being a mean tennis player and possessing an awesome palate, Bill was early in his correct assessment of Greenspan's easy money policies and how they contributed to massive asset bubbles.

Where does that leave us? In acceptance mode. The stock market may move beyond what is justified by the economy or by valuation. The only problem is that you will likely only realize this fact in retrospect.