Although the economy is beginning to recover, the strength and durability of the rebound remains to be seen.
Global stock markets entered a consolidation phase in June, following the sharp rally off the early March lows. Nothing has transpired during this correction, however, to alter our view that stocks made a major bottom in early March, and are in the early stages of a new cyclical bull market. This new bull market will likely be shorter and shallower than historical averages, because the economy will likely struggle to sustain positive real economic growth and the government will eventually have to face the reality of its fiscal imbalances.
But this bull market is only four months old, following the worst bear market—and longest recession—in over 70 years, and for now should be given the benefit of the doubt. If a deeper correction does develop at some point in the third quarter, we would expect the downside risk, using the S&P 500, to be limited to the 800–825 level, which would represent approximately a 50% retracement of the nearly 300-point move from the March 6 low of 667 to the June 11 high of 956.
We expect the stock market’s larger trend over the next 12 months, at least, to remain positive. According to the Economic Cycle Research Institute (ECRI), whose economic forecasting record is second to none, an end to the recession is in sight. The growth rate in ECRI’s leading economic indicators has turned positive for the first time in over 22 months, which is a reliable precursor to improved economic conditions. This constructive outlook from ECRI implies that economic data are more likely to surprise on the upside rather than the downside in the months ahead and that stock prices will rally through resistance to new highs in the course of the third quarter.
Despite vastly improved financial market conditions, investor sentiment remains cautious and skeptical, which suggests downside risk should be fairly limited. According to recent surveys conducted by the American Association of Individual Investors (AAII), more investors are bearish than bullish with respect to the stock market outlook over the next six months, and investors continue to hold an unusually high percentage of their portfolios in cash, which is earning a negative real (inflation-adjusted) return.
Investors are understandably dubious and paralyzed given (1) the carnage of the recent bear market; (2) their mistrust of the financial system; and (3) the litany of longer-term concerns (e.g., the monetary/inflation outlook; a seemingly intractable aggregate debt problem; the prospect of higher interest rates and a weaker U.S. dollar; the inability to envision an environment conducive to private sector growth, etc.), but we believe investor confidence will gradually return, allowing risk assets such as stocks to handily outperform “safe haven” investments such as cash and Treasuries.
As for the issues of monetary debasement and the prospect of sharply higher Treasury yields, these are very real risks, but not foregone conclusions, and in any case, the timing and severity of these outcomes is at present unpredictable. Our view is that these risks are likely to play out over time, and, while they should be closely monitored, should not dictate one’s investment strategy. We will be closely watching the Treasury and currency markets for potential warning signals. Thus far, both Treasury yields and the U.S. Dollar Index are trading within reasonable ranges.