With the market levitating again Monday, the inevitable question popped up of whether the bubble is reinflating. The answer depends very much on one's perspective.

Earlier, we examined the state of sentiment and showed how high levels of bullishness aren't always a great contrarian indicator or market-timing tool. Monday's action evinced as much with the Dow Jones Industrial Average rallying 2.2% to 9318.96, its highest close since July 5, 2002. The S&P 500 gained 2.2% to 1010.74, its first close above 1000 since June 20, 2002, while the Nasdaq Composite rose 2.5% to 1666.58, its best finish since May 23, 2002.

Notably, the June 6 intraday highs of 9216 for the Dow and 1007.63 for the S&P fell by the wayside, the latest "key resistance level" to tumble in this ongoing advance. The Comp, however, failed to surpass its June 6 intraday high of 1684. I'm sure some skeptics will be talking about this "negative divergence" in an otherwise wildly positive session -- for those long stocks.

"There can be no doubt the mania has once again emerged in full bloom," Alan Newman, the oft-bullish editor of Cross Currents wrote Monday morning, presaging a session that supported his contention. "There are no bears left and no sellers, only bulls and buyers."

Although 85% of the Big Board's 1.3 billion share volume -- light vs. recent levels -- was to the upside, advancers led decliners by a relatively modest 23 to 9 and by 20 to 11 in over-the-counter trading, where upside volume was only 68.4% of the 1.9 billion total. More positively, new 52-week highs swamped new lows 397 to 7 on the Big Board and 247 to 13 over the counter.

On the other hand, "bubbles are usually formed against a backdrop of complacency that in turn allows easy money to feed the excesses," wrote Tobias Levkovich, institutional equity strategist at Citigroup's Smith Barney unit. "When some market watchers worry about the stock price run-up, they often forget to discuss the vast bond rally, which smacks more of a bubble than the bounce-back rally in stocks off of extreme bearishness last October."

Some air came out of the Treasury bubble Monday as the price of the benchmark 10-year note fell 19/32 to 103 23/32, its yield rising to 3.18%.

The curious thing is Newman and Levkovich cited similar elements to arrive at diametrically opposed conclusions.

That's What Makes Markets

In his "fundamental case" for why "an extremely powerful rally from current levels" may yet occur, Levkovich cited the potential for pension funds to start buying stocks again en masse. According to the Federal Reserve's flow of funds , there have been only five quarters of net pension fund buying of equities since 1995, the latest being the first quarter of this year.

"These investors generally have been net sellers of stocks for years, and therefore could continue to add to their equity portfolios, as they did in first-quarter 2003," the strategist wrote. "Every 1% shift of pension assets could equal $60 billion of new equity market inflows."

Only five quarters of pension fund buying since 1995 may sound hard to believe, but it's true. Michael Clowes, editorial director of Pensions & Investments, explained that many firms couldn't make contributions to pension plans because they'd become fully funded in the mid-1990s. Because pension-fund administrators couldn't pay benefits out of contributions, they started selling assets, most notably equities. (As for the 1%-equals-nearly-$60 billion figure, total assets of public and private pension funds was $5.66 trillion as of March 30, according to the Fed.)

In the "one man's meat is another man's poison" department, Newman conceded pension fund-buying could support another upswing in stocks, noting 79% of public pension funds are currently underfunded after the three-year bear market.

"The basic problems for states like Illinois" -- which recently sold $10 billion of bonds, the biggest municipal bond offering ever -- "is that bonds now yield too little for the assumptions they must make about future retirees and they must earn those assumptions somewhere else," Newman commented. "So, the decision to buy stocks becomes their only choice, obviously without any regard of said decision."

Given the S&P's low dividend yield and historically high valuations, equity investments by pension fund administrators "amount to buying their pension beneficiaries' stock on margin, mortgaging both the future of the beneficiaries and the state" or company, he concluded.

Less dramatically, Jeffrey Saut, chief equity strategist at Raymond James, also offered some cautionary comments about the wisdom of pension fund investments in shares.

Given a hypothetical pension fund with $100,000 in assets seeking an 8.5% return and using an admittedly simple 50/50 split between stocks and bonds, Saut observed the following: A 50% investment in Treasuries yielding around 3% results in a return of $1,500. To achieve the $8500 "return bogey," the equity component thus has to earn $7,000, or a return of 14%.

"Given the implied S&P earnings yield of somewhere between 4.25% and 5.24%" -- depending on whether one uses estimates for operating or reported earnings -- "earning 14% on the stock side of your portfolio going forward seems like a bit of a stretch to us," Saut declared. "Moreover, if a corporation is unable to achieve its targeted 8.5% return on its pension plan, said corporation has to reduce its earnings even further to contribute more to its pension plan."

Fair Warning

Reading those missives about pension funds Monday, I was struck by how little talk there's been on the subject lately. Remember last fall when underfunded pension plans were one of the top issues purportedly spooking investors? It's funny how when stocks are falling people focus on the negatives and then forget about same when the market rallies.

But don't be surprised if people start talking about pension fund issues again as second-quarter earning season rolls around.

"Most CEOs will be looking for a reasons why they missed projections" and the need to fund pensions will provide a ready-made excuse, predicted Diane Garnick, chief strategist at Dresdner Kleinwort Wasserstein. "It will become a topic again."

Garnick believes earnings will largely disappoint because "fundamental structural problems" have not been solved," most notably pricing power hasn't returned and capital expenditures remain moribund. (Conversely, Smith Barney's Levkovich believes the Fed's aggressive stance and new tax incentives will "ignite renewed corporate capital investment," another element in his optimism.)

As to pension funds, specifically, "many companies allocate into equities under the belief they outperform in the long run," which is historically accurate, Garnick said. "But companies incur incremental risk to capture excess return. When it pays off, that return never gets handed down to employees" in defined-benefit plans.

When pension funds became fully funded in the mid-1990s, no company said to its retired employees, "we're going to give you 110% of defined benefits," she noted.

Finally, the stupefying fall in Treasury yields has overcome the positive effect of rising equities in terms of pension funds' assets-to-liability ratio, which was a negative 2.9% in 2003 through May, according to Ryan Labs. (In other words, pension fund liabilities rose faster than their assets.)

"As interest rates go down, the present value of future liabilities goes up," and vice versa, observed Frank Bifulco, director of research at Orazio Financial Services, a Suffern, N.Y.-based financial planning firm. "Bonds and stocks went up in value the last few months, but so did the present value of liabilities, more than offsetting the increase in plan assets for most plans."

So there you have it, something to worry about on a day in which very few on Wall Street seemed worried about much.

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to Aaron L. Task.

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