Why is the stockmarket rising when economies are struggling?

You'd expect stockmarkets to reflect the relatively bleak economic outlook, so why have they risen in recent weeks?.

Stockmarkets have generally been heading upwards lately, with the FTSE 100 today closing at over 5,600 points - its highest close since late April.

This is good news if you own stockmarket investments, but seems odd given there's still talk of global economic troubles and the possibility of some economies, including the UK, slipping back into recession.

So what's going on? Are the markets being overly optimistic? Or do they know something we don't?

Reasons to be optimistic

Most economies are out of recession - there are fears that the US and major European economies will fall back into recession (the so-called 'double-dip'), but for now they're technically out of recession and showing very modest growth.

Corporate profits are generally positive - there's no doubt that markets have been boosted by some strong earnings announcements from companies around the globe in recent months. The positive results are generally thanks to a combination of leaner companies (due to shedding some excess fat during the recession) and growing demand as the worst of recessionary gloom lifts.

Central banks may boost economies - even though there's widespread concern that Western economies will struggle, there's widespread belief that central banks will step in and pump money into economies to keep them moving.

Dividend yields attractive - the FTSE 100 yield currently averages about 3.3% net of basic rate tax (with some companies yielding well over 5%), which compares favourably to gilts at around 3-4% before deduction of tax. Some argue that shares are therefore undervalued, although you could also argue that gilts are overvalued...

Interest rates look set to remain low - this is generally good news for stockmarkets as it makes it cheaper for companies and consumers to borrow, which leads to more spending. Low interest rates on savings also encourages more people to buy shares rather than save.

Reasons to be worried

The impact from tax rises and spending cuts has yet to be felt - they could have a significant impact on consumer spending, hence company results and stockmarkets, especially in the UK. It's still very early days and once in full swing the Government's austerity measures could prove very painful for many.

Economies are still struggling - while most developed economies are now out of recession, they're far from firing on all cylinders. Things are finely poised and it won't take much bad news to send some economies straight back into recession.

Unemployment troubles - although US unemployment has steadied, it was still 9.6% in August 2010 - more than double the 4.6% in August 2007. High unemployment hurts consumer spending, which is bad news for companies - although it can help by driving down wage costs.

Emerging markets still depend on developed - growing prosperity in emerging markets means companies in these markets increasingly benefit from domestic demand, but they still rely on exports. If Western consumers are hurting from higher taxes and unemployment they'll probably buy less, hurting emerging stockmarkets in turn.

Why are gold, gilts AND stockmarkets riding high?

In simple terms gold and gilts are seen as safe havens, favoured by investors when nervous about stockmarkets. So it seems strange their prices have generally held up during the recent stockmarket resurgence (ok, gilts have fallen in price, but only by a little).

The best explanation that I can come up with is that although stockmarket sentiment has picked up lately, there's still plenty of nervous investors to prop up demand for gilts and gold.

The UK stockmarket is not an island

I know I've said it before, but when looking at the UK stockmarket it's important to remember that many of the companies listed on the London Stock Exchange trade globally. This means their fortunes depend on economies overseas and not just the UK - only around a third of UK stockmarket revenues come from Britain. Of course if overseas economies suffer that's a problem, but it does provide some insulation from the UK economy where prospects are arguably more gloomy than many overseas economies.

Verdict - I'm not sure the upturn will last

On balance, I think stockmarkets are suffering from a bad case of short-sightedness. Yes, there's been some positive profits announcements recently, but can most of these companies keep up profits growth if economies fall back into recession? I doubt it. And yes, central banks might step in to lend a hand, but this is like sticking tape over a leaking pipe - it might work for a while but it's not a permanent fix.

So stockmarkets, like too many things in life these days, seem to be obsessing with the present and paying too little attention to the future. I expect we'll get a stream of bad news at some point over the next few months and they'll fall back again...until the next batch of good news.

That's not to say you should ignore stockmarkets for longer term investment, but I'd tread carefully and expect volatility to remain high for a long while yet.

Perhaps stockmarkets have become like schoolboy football. Investors are too busy chasing news all over the pitch to take stock of the situation and organise a formation likely to succeed.

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