As the country prepares for the presidential election, there is one talking point President Obama′s team may use often. During his term, the stock market has regained the losses endured at the end of Bush′s term. It is a good talking point because it is true: At the end of 2008, the Dow Jones had fallen from historic highs to a low of 6,547. Now it hovers just below 13,000. In political terms, this is a good place be for an incumbent president.

However, while your investments look dramatically better now than at the end of 2008, it would be prudent to hold off on popping the champagne. The reality is that the Dow at 13,000 is like a table with a fine finish on top with rotten wood underneath.

Hidden time bomb

It cannot be disputed that the market has risen since the crisis of 2008 and that many companies are making profits, some with record earnings. It would appear that the market has regained its legs and is safe to invest in again. However, the problem is that the fundamentals underlying the market are weak.

For example:

  • The Congressional Budget Office (CBO) estimates a growth rate for the country at just 2%. Estimates for 2013 drop to only 1.3%. This is in contrast to the 6% growth rate that is expected for post recessionary periods, according to the Bureau of Economic Analysis.
  • The Euro zone still has not finalized debt issues related to Greece, Spain, and Italy. When you consider that most banking is still done through five major institutions in the U.S., all of which have deep financial ties to these countries, any defaults will spread a financial contagion that will adversely affect the markets and economy.
  • Industrial production growth in March 2012 was at 3.78%, as opposed to 5.34% for the month of March in 2011. A lower production growth rate means fewer large-scale goods being produced, or worse a sign of more production jobs being shipped overseas. In either case, that means less jobs, meaning less economic activity.
  • The latest Consumer Confidence report shows that U.S. households trimmed buying plans for automobiles, homes, and vacations. Consumers planning to spend less is a sign of not only lack of confidence in the economy, but in their own employment as well. Considering consumer spending accounts for 70% of the economy, anything hindering spending further weakens the country′s economic foundation.
  • Unemployment is projected to remain above 8.3% for the balance of 2012.

These economic indicators point to an extremely weak economic foundation in the country and do not justify the rise in the market we have seen. There is no logical reason for the market to be up, nor for many companies to be profitable. So the question remains: Why is the market up, and how are companies making money?

How companies make money in flat economies

No matter the size of a company, there are only two ways for it to be profitable:

  1. Profits by Growth: A company generates higher profits by expanding its market share, increased sales, and higher demand for its products. All three are indicative of an expanding and growing economy.
  2. Profits Through Cuts: Companies reduce their workforce with layoffs, close plants, or enact company divisions, and cut expenses elsewhere. Generally, the largest area of savings is through forced layoffs. If sales remain level, or even dip a little, the reduction in expenses allows profitability.

Profits by cuts is what the vast majority of companies €“ both in the Dow Jones and not €“ have accomplished in the last three years. The last six months of 2008 saw massive job losses in finance, banking, and real estate because of the mortgage implosion. This trickled down into nearly every other area of business.

Fast forward three years, and you can see that companies have cut expenses to the bone, and remain profitable as a result. But sales are not expanding greatly, and customers are not spending.

How perception skews reality

The challenge with evaluating the market in times such as these is that people sometimes forget that perception has a great deal to do with how the market moves. In its purest form, stock prices rise if the company in question makes money €“ how it makes money is not as important. If a company beats earnings expectations by $0.03 per share, the market goes wild. All that the market and the media see are the words €œearnings€ and €œprofits.€ What you do not hear is that the company beat expectations because they cut 2,000 jobs a year ago.

Another challenge is that when the market moves up, the perception of many investors is that it is a good time to invest in stocks. Therefore, people invest more of their money, and that helps push the market up further €“ or, at least, maintains the upward move. But we have seen this cycle before, and it never ends well.

Recent stock market bubbles

The late 1990s – Internet market rage: In the late 1990s, the stock market was in the midst of a wild ride. The word of the day was €œInternet,€ and Internet stocks were not just flying high €“ they were shooting into the stratosphere. It would be routine for stocks with ticker symbols like JDSU, CMDI, TOYS, YHOO, and EBAY to go up 20 or 30 points in a day. Every month there was a new IPO, and the term €œday trading€ became a job title that filled many with hope and awe.

The one problem, as we eventually found, was that most of the Internet companies were not making any money, and therefore there were no profits. Many had no real business plan, and instead were operating on the premise of, €œIf you build it, they will come.€ However, profits did not magically appear, and with a push from Federal Reserve Chairman Alan Greenspan, the dot-com bubble burst.

Some companies, such as eBay, Yahoo, and Amazon, survived, but only because they had a viable business model that would lead to profits. The rest disappeared because they lacked business fundamentals. This concept extended to the market as well. The excitement and movement of the market helped push it higher and higher, but it could not survive the underlying weaknesses.

The Bush years – Market up, hidden fractures below: During President Bush′s second term in office, the Dow actually reached a peak high of 14,000. The market rebounded from the lows it had hit in the wake of the 9/11 attacks, six years prior, and it had risen to that level in a steady fashion: Companies were making money, and many in charge did not think a major crisis was around the corner.

However, some people did understand that the market was higher due to a real estate bubble, and the massive amount of sub-prime loans were going to bring it all down. The real estate market was based on a circular pattern of buying with no money down, refinancing at a high value, or selling at a higher value.

On the institutional side, lenders knew the loans were bad, and sold bundles of them as soon as they could. These were in turn resold as weird and exotic investment tools. The fundamentals were weak, though, and when that was exposed, it all came crumbling down. Those lack of fundamentals, however, did not prevent the market from moving up for long.

Photo Courtesy of Emilio Labrador