Jobs can’t save the zombie stock market

March 4, 2011, 9:35 PM UTC

The economy is finally starting to move forward. But don’t be shocked to see stocks go the other way.

Friday’s jobs report shows welcome evidence that the struggling real economy is starting to catch up with our roaring, Fed-backed financial markets. Nonfarm payrolls rose by 192,000 jobs in February, the biggest gain since last May.

The S&P's long march

The news seems like it should rev up investors who have almost casually sloughed off news of surging oil prices, rising interest rates and unremitting Washington gridlock. The zombie stock market seems to walk through walls without breaking stride. Won’t an actual sighting of good news send it soaring?

Alas no. Stocks slipped on Friday, and even those who believe the recovery is gaining steam say we are headed for more of the same.

“We are overdue for a 5% correction,” says Dean Junkans, chief investment officer at the Wells Fargo Private Bank. “I’m surprised we didn’t get one with the Mideast oil shock, but the data in the U.S. has been really good lately and sentiment is definitely improving.”

That is true enough. The ISM services index rose for the sixth straight month in February, and its manufacturing survey employment index hit a 38-year high. IHS Global Insight economist says the U.S. expansion is now in the “sweet spot” of abundant spare capacity and generally low costs.

But it is a sweet spot that could easily turn sour. The commodity price spike that has sent up gas prices won’t lead to big inflation now, but it is likely to pinch corporate profits and stretch already thin consumer budgets.

A profit slowdown won’t be good for a stock market that is, by many measures, already at nosebleed valuations. Pepsi (PEP) warned last month that rising input costs are the worst it has seen in years, and other big producers will face similar pressures.

What’s more, the fuel that boosted the stock-market’s rocket recovery is about to wear off, as the Federal Reserve pulls back on its support for the bond market and governments trim payrolls to get bloated budgets into balance.

Every spending cut is going to hurt. Unemployment remains more than half a point above its level two years ago, when the S&P 500 index was trading at half its current level (see chart, right). Inflation-adjusted median family incomes haven’t risen in a decade.

Does something have to give?

The recent uptick in sentiment unfortunately ignores these facts — and with them the possibility that the market’s long honeymoon period will come to a crashing halt.

Almost everyone expects to see interest rates rise later this year when the Fed stops buying Treasury bonds. Most Wall Streeters say a hammering for bonds will be good for stocks, as investors try to fend off coming inflation.

But David Rosenberg, a longtime bear on the stock market who tracks the economy for Canadian brokerage Gluskin Sheff, says stocks and other riskier assets, such as commodities, may actually take the brunt of the blow.

He says this is what happened around this time last year, when the Fed ended its first program of quantitative easing. Stocks swooned and oil prices fell. Many observers blamed the selloff on the Greek fiscal crisis, but Rosenberg says it’s unwise to underestimate the degree to which Fed liquidity is supporting all asset markets.

“So who buys the bonds when Ben leaves the building?” asks Rosenberg. “The same folks who were the buyers last year from April to August. The ones who were switching out of equities, commodities and other risk-assets.”

Or, put another way, the end of QE2 could be a sinking feeling for stock investors.

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