10/11/2011 05:07 EDT | Updated 12/11/2011 05:12 EST

Canada Economic Forecast: Markets Rally, But Real Relief A Ways Off

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OTTAWA - Beware the relief rally.

The stock markets have bounced up six per cent from the low point reached last week, but many analysts are warning against what Alan Greenspan once called "irrational exuberance."

The fundamentals that frightened investors into slicing about 20 per cent from Canada's main stock index since March, are little changed despite a mini-rally since last week, they say.

In Toronto, which was idle Monday for a holiday, the TSX composite jumped 287 points Tuesday to close at about 11,875 points.

That's up about 700 points in the week since Oct. 4, when the index closed at 11,177 points. Earlier that day, the market had fallen to its lowest level since October 2009 before recovering later in the session.

"I think equity markets are hopeful the crisis is over," said Craig Wright, chief economist with RBC.

Markets are regarded as a forward-looking indicator, suggesting that the smart money is betting on European leaders coming to grips with the Greek and other national sovereign debt issues, as well as the recapitalization of jeopardized banks. And they are betting that a U.S. recession may be averted.

It remains to be seen how markets react to Slovakia's rejection late Tuesday of the European emergency bailout fund, which requires unanimous approval by the 17 member countries.

Optimism resurfaced at the mid-point of last week after European leaders suggested they were preparing to mount a defence of their banking sector. It continued Friday with fresh data showing both the U.S. and Canadian economies continued to add jobs in September. And it took off over the weekend when French and German leaders pledged, without giving details, to contain contagion.

There are some reasons for optimism, said TD Bank's Derek Burleton. He notes that the gloom was based on three crises in confidence — skepticism over the ability of European policy-makers to act, cynicism over Washington's dysfunctional government, and the real worry that the U.S. was heading into a second recession.

"On Friday and over the weekend, you had some easing in two of those fronts, and so you have some easing of concerns," Burleton said.

There was more encouraging news Tuesday. In Europe, international lenders recommended that Greece be given the next instalment of its debt relief package, worth about $11 billion, to stave off bankruptcy a little while longer.

And in Canada, the housing market continued to defy predictions of a slowdown as construction starts rose to a seasonally adjusted annual rate of 205,900 units last month, an indicator the economy is far from contracting but also sending out alarms about a housing bubble ready for bursting.

Steve Hanke, professor of applied economics at Johns Hopkins University in Maryland, says market optimism is not only misguided, he calls it "ridiculous."

"Europe is just a matter of arithmetics and the numbers are astoundingly bad," Hanke says.

If Greece is the issue, it is falling deeper into debt with each bailout, rather than getting closer to solvency, he says.

"The U.S. and Europe are going into recession again, and it will happen early next year and maybe later this year."

In a note to clients, economist David Rosenberg of Toronto-based Gluskin Sheff wealth management, also took a dim longer-term view.

The economy may not be contracting now, he said, but the forward looking indicators are trending lower. He points out that Friday's jobs numbers in the U.S. were far from robust — hours worked did not rise and overtime hours fell. As well, erosion in real disposable income is starting to set in.

Rosenberg compares the current situation to 2007 when markets were fooled by moderate growth into thinking a soft landing was occurring, when in fact the recession had already begun.

Even the optimists concede that a three- or four-day rally does not spell the end of concern. Risk is still very elevated, and the fundamental weaknesses in the global economy have not been shored up.

Bank of Montreal economist Doug Porter points out that in October 2008, as the economy was tumbling into a deep global recession, markets staged wondrous one-day rallies that signified nothing but wishful thinking.

But the question is whether the recent rally was an over-reaction, or a correction to the excessive pessimism of the past few months.

"I would argue the starting point was irrational pessimism," said RBC's Wright, whose bank is more bullish about the economy than most others. "People threw around speculation of a recession, but I suggest that was the risk scenario not the base scenario."

The most likely scenario, says Burleton, is for markets and the economy to bounce around for the next several years, provided, he adds, Europe does not actually fall into a crisis that spreads to the rest of the advanced global economies.