Caution needed in times of greater optimism

Bob Doll, global chief investment officer for Black Rock, provides his weekly investment commentary from New York

May 28, 2009 - Continued signs of better economic conditions and improving corporate earnings estimates helped stocks post marginal gains last week. The Dow Jones Industrial Average rose 0.1% to end the week at 8,277, the S&P 500 advanced 0.5% to 887 and the Nasdaq Composite climbed 0.7% to 1,692.

Last week’s headline economic news was the Conference Board’s announcement that the Index of Leading Indicators rose more than 1% in April—the first gain in 10 months. The data showed that consumer expectations have been improving and that some business and manufacturing statistics have been recovering. On the earnings front, all 10 sectors have been showing net improvements over the past month and analysts are now expecting to see positive year-over-year comparisons by the fourth quarter of this year.

Late last week, Standard & Poor’s warned that the United Kingdom was in danger of losing its AAA rating over the next couple of years. There also have been concerns that the United States might not be far behind. We were encouraged that financial markets weathered this news fairly well and, at this point, it does seem clear that most investors are relatively optimistic about the global economy. Policymakers have been diligent in fighting credit deflation and we expect the Federal Reserve will continue to promote liquidity through the next year, although we are becoming concerned about some of the legislative priorities in Washington.

The rapid increases in deficits will become a problem before too long and once the economy does begin to stabilise, the likelihood of higher tax rates will increase. This scenario adds a growth- and market-unfriendly component to our outlook. On balance, we expect to see the beginnings of a slow and below-par economic  recovery in the second half of this year, with growth accelerating somewhat in 2010.

The market rally that began in early March has resulted in a trough-to-peak advance of approximately 40% for US stocks. The upturn was dominated by lower-quality investments, with the highest-quality decile up barely 20% and the lowest-quality decile up 150%. That rally was based on a combination of oversold conditions, diminishing concerns about the nationalisation of the banking system, the announcement of some new government programs and, perhaps most significantly, a series of “less bad” economic data. We believe it is important to remember that less bad economic news is not the same as actual good news. As such, we believe the rally that started in early March may have run out of steam and that a resumption of the rally will require more solid evidence of an economic recovery.

At present, we believe equities are entering a correction phase, although we believe this correction will be marked more by sideways action and less by a sharp decline. We think it is extremely unlikely that prices will retreat to   their early-March levels, but we could see a near-term decline to between 800 and 850 for the S&P 500. Over the longer term, we expect improving economic conditions will help prices move higher and believe that stocks will outperform bonds and cash over the next 12 months.