Investing Knowledge

"Markets have gone up too much, too soon, too fast."--Nouriel Roubini

Prof. Roubini, known for having predicted the economic crisis, proclaims he's cautious in the near term because of a weak economic recovery. George Magnus, economic advisor at UBS (Virt-X: UBSN.VX - news) , agrees, saying, "This recovery is entirely dependent on the unprecedented largesse of governments and central banks ... the recovery is built on very short-term foundations."

This doubt about the economy is all well and good, but one only needs to look at the recent stock market recovery to find some seriously optimistic expectations.

We Must Be Dreaming

Since the March lows, the MSCI World Index has climbed by 74%, the S&P 500 (news) has jumped 59%, and the FTSE 100 has soared 47%. Healthy companies like Rightmove (LSE: GB00B0MFTM73.L - news) (LSE: RMV) and Ashmore Group (LSE: ASHM.L - news) (LSE: ASHM) have rebounded more than 150% over the same time period, and even bedridden shares like Royal Bank of Scotland (LSE: RBS.L - news) (LSE: RBS) have been able to jump 78% since March, and 200% since their January lows.

Bulls are pointing to a fast, V-shaped recovery that will mirror the quickness of our slide into recession. Could a full recovery really be this immediate?

There Goes The Alarm

The short answer is no -- this can't be as prompt a recovery as some believe. Here are three reasons why I believe this rally is a castle made of sand.

• Deleveraging: Household balance sheets are fundamentally linked to property busts, which often take years to play out. People will continue to spend less and consume less as they realise the reduced worth of their assets. This is the ultimate hurdle as the economy struggles to grow, since consumer spending accounts for around two-thirds of the UK economy.
• Government spending: Unfortunately, it seems as though our taxes have been behind much of the rally. Bears point to the fact that car sales will slow after the government's £2,000 car scrappage scheme ends. Consumer spending may take a hit when VAT returns to 17.5% in January. As the threat of inflation increases, government spending will slow. Magnus states that "if you don't have credit growth operating, it is hard to sustain spending while unemployment is still rising." In other words: Let's not count on the government to get us out of this mess.
• Interest rates: Central banks worldwide have kept interest rates as close to zero as possible, which has increased the flow of capital into the stock market. But many people believe low interest rates (cheap money) are one of the reasons we got into this fix and think the Bank of England will have to raise rates sometime next year. Would investors really be throwing their money into shares if they could earn 5% in a savings account like they could in 2006 and 2007?

This Is No Time To Snooze

OK, so what can you do?

You can look for growth shares, companies like Autonomy (LSE: AU), for example. But despite the stock market surge, Magnus argues, "the economy doesn't really go anywhere." Translation: This may not really be a great time for growth.

You can try to play it safe and look for dividend-paying shares that have some possibility of appreciating in price. However, even steadfast, reliable companies like HSBC (LSE: HSBA.L - news) (LSE: HSBA) and BT Group (LSE: BT-A.L - news) (LSE: BT-A) have had to slash their dividends. It's difficult to know which dividend shares you can count on in a turbulent market.

The smart move is to follow in the footsteps of investing gurus like Benjamin Graham, Warren Buffett, and David Dodd. In any environment, good or bad, there will always be undervalued shares -- the tricky part is finding them.

Our analysts at Champion Shares PRO are constantly on the hunt for great companies that are selling below their true value. These companies are operating profitably, are trading cheaply, and have responsible and reliable management. In fact, many exhibit strong growth and pay a dividend -- so we can have the best of both worlds. The PRO service is currently closed to new members, but if you'd like to be alerted the instant it re-opens, click on the 'Champion Shares' tab on www.fool.co.uk. 

> A version of this article was originally published on Fool.com. It has been updated by Bruce Jackson, who doesn't have an interest in any of the companies mentioned in this article.