The calm before the storm

Felix Salmon at Portfolio.com:

My feeling, mainstream as it may be, is that stocks are drifting upwards in blissful ignorance of reality, much as they did for nearly all of 2007, even after the credit crisis first hit. The panic sellers and the people desperately needing liquidity have left, volumes have fallen (as they always do around the holidays, no news there), and volatility has decreased. And so both value and momentum players are feeling increasingly comfortable rotating back in to the market.

But if the recession gets to be as bad as people are increasingly expecting, fundamentals will eventually start asserting themselves -- and if we're unlucky, they'll do so in a violent downward manner, much as they did last fall. Remember that the bond market is pricing in a serious wave of defaults -- and I don't think the stock market is. If and when those defaults arrive, with shareholders of the companies in question being largely wiped out, will the broader indices really remain unaffected? And more generally, a two-year-long recession does really nasty things for corporate profits, which rise much faster than GDP in boom years, but fall much faster than GDP in bust years.

Many stocks are way overpriced. Earlier this week I made the example of Toll Brothers (NYSE:TOL). As I pointed out, this is a company with extraordinarily high exposure to the high-value housing market in New York City which is in the midst of a free-fall collapse as I type. That this company has had less than a 20% correction from its highs is not a sign of corporate endurance but a sign of impending doom. The more investors keep stocks like this propped up, the harder the fall will be.