Reports of disappointing economic news continue, as the latest increase in the unemployment rate to 9.8% certainly signifies. In California the news is only worse, with an unemployment rate exceeding 12%, and a state government facing a massive budget deficit with employees taking furlough days. Despite all the bad news, the stock market is now trading at its highs for the year, as of Dec. 13. Is this irrational exuberance on the part of the market or are things actually starting to improve? I believe the recent rally in the stock market is justified and will try to explain.

The recent employment report showed a paltry increase of 39,000 jobs for November but the month of October was revised upward to an increase of 172,000 jobs created. Averaging the two months shows an increase of just over 100,000 workers, which likely implies an economy that is expanding, albeit at a modest pace. Furthermore, new unemployment claims, which tend to be a leading indicator, have been trending down in recent months. The Purchasing Managers Index, for both services and manufacturing, during November also showed results consistent with an economy that is expanding.

Retail sales, a good measure for consumer confidence, are starting to show improvement. Even new car sales are starting to accelerate, with the last two months exceeding 12 million units annualized, without any special incentives. This is a significant increase compared to the period in early 2009, when sales were less than 10 million units. However, even with the recent strength we are still far below a more normal sales pace of 15 million to 16 million units.

For the stock market, two key variables to focus on are interest rates and earnings. Interest rates remain at very low levels, even with a significant increase in longer-term rates over the past month. Corporate earnings have been rebounding quite strongly despite the sluggish economy and should finish 2010 within 10% of their all-time high, reached prior to the start of the recession, and may establish a new high in 2011. Helping corporate earnings are international sales, which account for close to 40% of profits for companies in the S&P 500 - an index of 500 large U.S.-based companies. Even with corporate earnings approaching their prior peak level, the S&P 500 is still approximately 20% lower than its high, reached in 2007.

The economy remains far from healthy, but fears of a double-dip recession are exaggerated, I believe, especially now with the likely passage of a new tax stimulus bill. The unemployment rate will likely remain elevated for a number of years, but corporate earnings can still expand with a sluggish economy.  For someone who is a long-term investor and has some tolerance for risk, a moderate allocation to the stock market is appropriate in the current environment. This is especially the case given that other alternatives, such as money market funds and bonds, are offering below-average yields. However, someone with a short-term time horizon, such as someone saving money for a down payment on a house, should refrain from equities because of normal stock market volatility.