There is a new mood of optimism in the United States, which has expressed itself in the stock market over the past eight weeks. Yet the risk that stocks will decline seems greater now than the likelihood of a sustained, permanent rally. 

The US market enjoyed another strong day on Friday, with the S&P 500 Index rising 2.41% to 929.23 points. Fund managers cite the release that morning of data from the US Labor Department. Although the government reported the economy lost another 539,000 jobs in April, bringing the unemployment level to 8.9%, this was not quite as bad as expected. The market consensus had been that April would see 600,000 jobs lost.

This sort of thing has been going on since the beginning of March, when Citi announced its first two months in 2009 had been profitable. "We know that a very negative event can turn things, but right now investors are shrugging off negative news," says Arlene Rockefeller, global equities CIO at State Street Global Advisors in Boston. Bad news in the auto sector or the prospect of further bank write-downs on assets have not phased investors. "It would take a lot to turn sentiment," she says.

The more optimistic investors acknowledge that unemployment is going to get worse, but say since March, the bad news has all been less bad than expected -- as opposed to the months following the collapse of Lehman Brothers, when the news was consistently worse than investors had thought.

Sean Fitzgibbon, an equities portfolio manager at The Boston Company Asset Management (which is owned by Bank of New York Mellon), counts himself among the optimists. The previous foci for risks have been addressed, such as fears about another bank going down like Lehman, or nightmare scenarios about credit spreads. While conditions are not good, the Armageddon scenario has been taken off the table.

"The market is catching up now," he says, adding that more companies' earnings reports are now providing upside surprises. This is, admittedly, due to cost cuts rather than top-line revenue, but companies are in a position to grow earnings if things pick up. "We could see another 20% upside this year thanks to revaluations of multiples," he says.

Other investors, however, believe this is simply a bear-market rally and that the US stock market will retrace losses. Historically, such rallies have driven gains of 30-50%, and the S&P 500 has reached this range over the past two months. "We've gotten the gains we can get," says one portfolio manager, who was unauthorised to speak on the record. "Equities are fairly priced now and it's hard to argue that the market will rise from here." 

He and other managers find the recent outburst of investor optimism a bit puzzling. The fundamentals have not changed. Deleveraging remains the prerogative within the banking system and among consumers. This means that, although S&P 500 companies have repaired their balance sheets, there is little prospect for growth. The news was better than expected in the first quarter, but there's no basis to support the notion that this will continue.

"Optimists are anti-bears," says this manager, "but are they really bulls?" He says the idea that there will be no more bank failures should not be assumed so easily. So far defaults have been rare but they are likely to come, in spades. And creeping anti-capitalism and the expansion of government activity throughout the entire economy does not bode well for growth. "This doesn't add up to business as usual for 2010," he says.

Other managers say that the market is ignoring important signals in its rush to embrace news that has not been as bad as expected. Take Friday's Labor Department figures, for example. Although the non-farm payroll losses were not as bad as expected, the optimists have failed to account for another piece of data: aggregate hours worked.

This is a forward-looking indicator that currently suggests things are still getting worse, not better. The idea is simple: companies are laying off workers and maintaining hiring freezes. They will do so until after business has already picked up. This means a fixed labour pool will have to work more to handle growth in business before companies start to add new staff.

But the Labor Department says aggregate hours worked in April declined by 0.5%. "This very good forward indicator is telling us that we cannot expect job gains or jobs growth in the coming months, because first we need to see existing workers put to use for longer periods, and we are not seeing that," says James Swanson, chief investment strategist at MFS Asset Management in Boston.

He calls the present rally "thoughtless" because it is not linked to an improvement in the economy. If talk in January and February of Great Depression-like levels of unemployment and defaults was wide of the mark, so is the current bullishness.

Ben Inker, partner at GMO, says stocks initially deserved their rally in March, because they were so cheap. "I'm nervous about how it happened," he says, noting that quality blue-chips rose only about 11%, while those trading at $5/share or less were the ones that leaped in value. His analysis: the rally was driven by speculation, not on the back of fundamental improvements, and that the biggest gains took place in the least attractive stocks. Investors are better off buying the debt of such companies, Inker says.

He argues that investors have yet to accept that the kind of corporate earnings they came to accept as normal in the mid-2000s have always been illusory. Inker reckons that investors have become used to thinking of earnings as 15% above a more realistic 'normal' rate. The onslaught of deleveraging means corporate profits for the next decade may well come in at 15% below the realistic 'normal'. This means that profits will be 30% below what investors mistakenly expect. Although Inker is not predicting the same huge drops that previous bear-market rallies have suffered, he does say that believing in the rally at this point doesn't make sense.

"I'd be surprised if there's a lot more on the upside," says SSgA's Rockefeller. She thinks sentiment has turned enough to put a floor beneath some of the market's gains, but is not confident the rally can maintain its pace: "Are earnings improving, or just beating low expectations? We need to see proof in the pudding."