Over-optimism setting stage for a crash?

The big news on Bloomberg today: U.S. Stocks Rally as Dow Hits 10,000 for First Time in Year . Spurred by the positive earnings report by Intel and JP Morgan, the market continues its rally to new highs for the year. Seems like every company out there is beating the EPS estimates. I read an article which mentioned a survey that claimed that 80% of Americans think that the recession is over.

I have also been looking at some charts I get through various newsletters and many claim that we have broken important resistance levels. Levels like the 50% retracement from the highs of two years ago and important fibonacci extension levels of the first recovery wave have been broken. Next important resistance area lies in 10,500-10,800 for the DOW.

Great! Let us all go out and load up on stocks because if we don't get on the bandwagon up, we are sure to miss out on an excellent opportunity.

But, an intelligent investor will ask if this rally makes any sense. Let us take a look:

GDP
The S&P has rallied a whopping 62% since the lows in March. How has the overall economy performed in the same time period?

Well from Q1 to Q2, the US GDP shrunk .1%. In the same time period, the S&P rallied 41.7%.
Q3 GDP growth is estimated at 3.4% while the S&P has rallied 14.7%. At least the divergence has shrunk.
The growth outlook for the next quarter is .3% and if we are to believe the 10,500 target for the DOW, the market will rally another 5%.
The conclusion I draw from the above numbers is that the rally is definitely overinflated and has little economic basis.

Earnings
When the market crashed last year, the analysts cut their EPS projections to abysmal lows. Now, when the economy is on the path to slight recovery, is it any surprise that the companies are beating their EPS estimates? When your EPS estimate is $1 and you make $1.1, are you truly performing that well? I have seen many companies' stocks jump 5-8% when they beat their earnings by a mere penny.

It is somewhat ridiculous to see stocks extending their rallies on such modest EPS reports just because they beat the analysts' estimates. According to various sources, the average P/E ratio is now in the 140 range! (I must admit that 140 seems ridiculously high and if I get time, I will calculate it myself and check the validity of the above claim).

Overall, I think the economic validity of this huge rally is at the very least questionable. The more we extend this rally without a significant correction, the more wary I get. Of course I am a little bitter today because the unexpected pre-earnings jump in many of my positions caused me some big losses. In any case, until I see some strong economic growth numbers or a reduction in the P/E ratios I will be very careful in entering any new long positions.

- Wown
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