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Rising optimism on the economy. A powerful summer rally. What's not to like about equities? Plenty
The start of autumn has brought a wave of new optimism to Wall Street, but not everyone is buying it.
Investors of all stripes generally agree that the economy has bounced back a bit after tough times in 2008 and early 2009. "Economic activity has picked up following its severe downturn," said the Federal Reserve in a statement on Sept. 23.
But while many market participants have been predicting the recovery will be slow, several widely watched economists are now predicting explosive growth, even for the troubled U.S. economy.
Cheerleaders for Recovery
"Doom's Left the Building, Gloom Dissipating," was the title of a Sept. 18 note from RDQ Economics, which noted growth "could exceed our expectations of only modest 2.5% growth through the end of 2010."
"Let the Good Times Roll," Deutsche Bank (DB) economist Joseph LaVorgna titled a Sept. 17 note. On Sept. 24, Barclays Capital head of research Larry Kantor wrote: "The U.S. is exhibiting all the characteristics of a classic, V-shaped economic recovery—just as we have seen in most of Asia—that is typical following a severe recession."
A common phrase—used by strategists at Barclays and Deutsche Bank and other commentators—is that the economy and the markets are in a "sweet spot." Businesses are replenishing inventories. Massive government stimulus is working. Even the long-suffering U.S. housing market may be getting better.
These bullish commentators might be early in recognizing the potential strength of the economic recovery. But they also might be late: The Standard & Poor's 500-stock index is already up 55% since its March lows.
"It's the economists catching up to the stock market," Jerry Webman, chief economist at OppenheimerFunds, says of the recent bout of optimism. He says that, though the long recession is over, there are still significant drags on the U.S. economy.
"These people are just kidding themselves if they are still extremely bullish at these levels of the market," says Dave Rovelli, managing director of equity trading at Canaccord Adams. Based on 2009 earnings, "we're already overvalued," he says. And "there are a lot of headwinds in 2010."
Investors Remain Cautious
Despite the arrival of some cheerleaders, the investing public is still skeptical.
Rob Lutts, president and founder of Cabot Money Management, notes that investors still have almost $3.5 trillion sitting in money-market funds earning almost no return at all. He sees the same cautious attitude in his clients. "People are still positioned very defensively," Lutts says. "They all have money squirreled away earning nothing."
The trillions of dollars in cash sitting on the sidelines can be "fuel" for further market gains as investors' mood gradually improves and they look for better returns, he says.
Doug Noland, portfolio manager of the Federated Prudent Bear Fund (BEARX), says investors are right to be cautious. "It's a dangerous economic recovery," Noland says. Fueled by government stimulus, the recovery in markets and the economy isn't on sound footing, he says.
"You get these bear market rallies, people get fully invested and, eventually, they get the rug pulled out from them," Noland warns.
In the short term, earnings from the third quarter—which for many companies ends Sept. 30—could be a key to either easing investor fears or bolstering them. A stronger-than-expected economy could produce stronger-than-expected results. "You may see a surprisingly strong third quarter," Webman says, noting that both consumers and businesses have a lot of pent-up demand after the last year.
But Scott Armiger, portfolio manager at Christiana Bank & Trust, believes earnings could still show plenty of weakness. "Consumers are not really spending," he says. "They're still focusing on needs and passing on wants."
"I think the market has gotten way ahead of the economy," he says.
Beware of Market Swings
Wall Street's optimists could help push markets higher for now, but they warn of dangers ahead. If we're now in a sweet spot, they warn, it might just be temporary. Eventually, the bill will come due for government stimulus. Interest rates will move higher. And the market rallies will lose steam.
"Investors may need to be nimble, especially given how far markets have already come," Barclays' Kantor warns.
A sharp recovery, in other words, creates its own problems, like fear of inflation, that policymakers must deal with. At the same time, many of the economy's underlying problems—with high levels of consumer, corporate, and government debt, for example—are unresolved.
It's a combustible mix for investors and could produce an era reminiscent of the wild market swings of the 1930s. Rather than a slow, steady recovery, we may need to prepare ourselves for a volatile environment where it's especially difficult to predict what—whether crisis or euphoria—is really around the corner.