Stockmarket surge is driven by blind optimism, not economic recovery

So much for selling in May. British shareholders have enjoyed their biggest summer gains in 25 years, and the FTSE 100's 40% advance since March marks its best six-month run in 50 years. America's S&P 500 index has gained 50%. But the boom is unlikely to last. Markets "have decoupled from reality", says FAZ.net.

The pattern so far has been that risky, cyclical stocks have left solid defensive stocks, such as utilities, standing. Industrial metals and mining stocks geared to the economy have been among the top performers internationally, as Tim Price of PFP Wealth Management points out in the FT, while firms with dodgy balance sheets have outperformed the rest of the market.

Financials have outperformed too. In America, Citigroup has risen four-fold off its March low, while in Britain the combined equity value of the three biggest banks Lloyds, Barclays and Royal Bank of Scotland is just 15% below the average level of 2007, says Jonathan Pierce of Credit Suisse.

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Market optimism is running rampant, with Merrill Lynch's monthly survey of global fund managers revealing that more managers are swapping cash for shares, says Morgan Housel on Fool.co.uk. Cash balances have fallen to an average of 3.5%, and 34% of managers are overweight equities, the lowest and highest figures respectively since 2007. But investors are ignoring inconvenient truths. Take US earnings, says David Rosenberg of Gluskin Sheff.

Analysts are now pencilling in year-on-year, third-quarter earnings of 20.6%, a downgrade from April's forecast of 17.2%. "The notion that earnings are improving is not exactly supported by the facts." (See below for more.)

Neither is investors' apparent confidence in a rapid economic recovery. The improvement seen so far has been underpinned by unprecedented fiscal and monetary easing. "As long as economic growth relies on the state, you cannot talk about a durable recovery," says the European Central Bank's Yves Mersch. Battered banks hoarding cash and companies and consumers paying down debt don't exactly presage an "effortless" rebound either, says Price.

Yet investors are evidently hoping for a return to the pre-credit-crunch days. "A lot of people are now counting on everything to go right," agrees Housel. And "that's a scenario more likely to end in tears than triumph" with the economy this fragile.

The big picture: US earnings a mirage

Second-quarter S&P 500 earnings may have exceeded reduced expectations, but year-on-year profits were still down by around 28%. And as Tom Lauricella says in The Wall Street Journal, the results were driven by unprecedented reductions in overhead costs.

Selling, general and administrative expenses (SG&A), such as salaries and travel and advertising costs, fell by an annual 6.4% in the second quarter, compared to 4.1% in the 1991 recession and just 0.2% in 2001.

Sustainable profit growth requires sales growth, but with unemployment mounting and consumers retrenching, that's a tall order.