Intro

MARKETS WOBBLED THROUGH

June, besieged by grim economic data, rising fears of inflation and soaring oil prices, all of which our pundits noted with growing concern, tinged with a bit of optimism.

Then came last Thursday's selloff, which dropped the S&P 500 3% in a day, pulling it to negative territory for June. The index closed Friday down 2.8%, off a midmonth gain of 8.47%, eliciting some unusually strong opinions from market forecasters.

"By any measure, today was a train wreck, equities off 3% taking us to new lows for 2008," J.P. Morgan Chief U.S. strategist Thomas Lee wrote in a June 26 note. "Oddly, it seems like it is easy to list off a major list of worries...but difficult to think of positive catalysts."

Lee had plenty of company in his gloomy corner, as other strategists fretted over the price of oil, which hit a record $142.99 a barrel June 27, as well as inflation, unemployment and the misplaced mid-June optimism.

"Earnings estimates seem too high and are likely to experience downward revisions," Citigroup's Tobias Levkovich wrote June 23. "It seems altogether repetitious to highlight this ongoing issue of analysts' estimates being excessive and the likelihood that numbers will be trimmed across a wide swath of the sectors; indeed, the equity market implications are not that shareholder friendly."

Nor are the conditions beyond Wall Street. Ed Hyman, at the ISI Group, noted June 11 that "Main Street is being hit by higher food and energy costs, slumping house prices, restrained credit availability and restrained wages."

Charles Schwab strategist Liz Ann Sonders argues that business is now on the second down leg of "a W-shaped economic cycle."

"The recent pickup in growth symbolized by the middle upward part of the "W" was driven by the stimulus package and strong exports. But we feel that this brief respite is over, and we're facing another bout of weakness, at least rivaling that of the first leg down," Sonders wrote on June 23.

That possibility also occurred to the generally optimistic Ed Yardeni of Yardeni Research, who allowed that things may well get worse before they improve. The U.S. economy remained resilient over the last 12 months despite the credit crisis, housing collapse and oil price surge, thanks to an active, interventionist Federal Reserve Board, which aggressively cut interest rates this spring before putting the brakes on in June.

"Unfortunately, there may not be much more that the Fed can do to stimulate economic growth should the resilience of the economy continue to be tested by the credit crisis and oil prices," Yardeni wrote June 23.

Tax rebates would keep spending moving along through July, but the stimulus is limited. "The question is, then what? Congress might approve a second round of stimulus payments if the economy is still faltering. Oil prices might drop as global demand declines along with global growth. The Fed and the Treasury might implement new measures to help the banking system raise capital. Or else the recession might not be as short and shallow as [we] have been predicting. If so, we think it might last longer, but remain relatively shallow."

Before the oil price spikes and the market breakdown, Jeffrey Kleintop, chief strategist at LPL Financial, took a longer view that still seems plausible, should some of the clouds lift. He maintains that stocks are stuck on a different letter of the alphabet.

"We believe that this year's heightened uncertainty surrounding the four "E"s election, energy, economy and earnings may lead to even more volatility than seen during the summers of most election years," he wrote June 9. "The summer volatility, while frustrating, is likely to remain range-bound and give way to a fourth-quarter rally. By the fourth quarter, the uncertainty surrounding the four 'E's is likely to have lessened."

At Merrill Lynch, chief strategist Richard Bernstein, whose pessimistic pronouncements have frequently been borne out in recent months, advised investors to be smart, surrendering to neither bullishness nor bearishness.

Bernstein describes a "great divide" in investor sentiment between expectations of inflation or disinflation, global prosperity or a global slowdown, a rush to commodities or a flight to bonds. He warns that an all or nothing choice isn't a solution.

"Instead of waiting for the outcome, however, we think it's more prudent to begin searching for investments that might outperform regardless of who is eventually right," he wrote June 10. "The way to do that might be to look for investment opportunities that do not depend on taking a hard stand on one side of today's hottest disagreement."

In this uncomfortable economic climate, though, that's easier said than done.

Also See:

• Economy Eases Back From the Brink for Now

• April Brings Shower of Uncertainty From Experts

• Experts Ponder How Long Recession Will Last

Pundit Predictions

There seems to be a Great Divide among investors. Today, perhaps more than at any time in memory, there is extreme disagreement among investors about how portfolios should be structured, and which investments are likely to outperform. Investors are at one end of the spectrum or the other. Should they invest for inflation or disinflation? Have global economies de-coupled, or is the U.S. leading the world into an economic slowdown? Are commodities the "new new thing," or should investors be buying bonds? Both sides make cogent arguments, but the debate may not do enough to help investors minimize their risks and maximize their returns. (Merrill Lynch Research, June 10)

Bill Gross, Pimco

From Bill Gross's open letter to presumptive President Barack Obama

:

"A trillion dollars of government deficit spending is potent medicine. Its potency regarding inflation will not be felt fully during the peak deficit period. Rather, inflation will accelerate during the subsequent recovery as the government bonds acquired during the recession are transformed once again into risk-bearing assets and high levels of investment. That suggests that intermediate and long-term yields on government bonds have already bottomed and will gradually rise throughout your first, and perhaps second Administration. Your term will not go down in history as investor friendly." (Pimco Investment Outlook, July)

Ed Hyman, ISI Group

To be sure, the economy is weak. Consumers are under pressure in both developed and emerging economies. If oil says around $133, its four-quarter average year-over-year change will peak at 72% in the third quarter. According to our forecasting model, this will reduce GDP growth by -1.5% from what it otherwise would have been. (ISI Group Research, June 20)

Jeffrey Kleintop, LPL Financial Services

The biggest risk to the markets is probably no longer a U.S. recession, but instead the potential for higher inflation. The rise in bond yields and stock prices over the past two months reflected better prospects for economic growth rather than higher inflation. However, two weeks ago markets may have reached the tipping point in inflation expectations as yields rose while stocks fell when oil moved above $125 per barrel. Worries over energy price pressure on inflation may help to keep the stock market constrained this summer as the four "E"s Energy, Election, Economy, and Earnings keep the stock market in a volatile but range-bound environment leading up to a fourth quarter rally. (LPL Weekly Market Commentary, June 2)

Thomas J. Lee, J.P. Morgan

Rising oil is a threat to our base case which we are watching carefully. We are still long equities, expecting a cyclical upturn in coming months. Oil could be the foil, particularly as it strains household finances and fuels inflation. Still, as [our] analysis of the 1978/1979 [oil shock] period shows, the U.S. is arguably in a better position today and equities then even still managed an impressive 29% gain. Our base remains intact and as we noted a few months ago, we expected the focus of investors to move towards inflation and the recession and away from the credit crunch. We still see the big trades in 2008 as being energy, financials, and discretionary. (J.P. Morgan Equity Research, June 16)

Tobias Levkovich, Citigroup

Earnings estimates seem too high and are likely to experience downward revisions. It seems altogether repetitious to highlight this ongoing issue of analysts' estimates being excessive and the likelihood that numbers will be trimmed across a wide swath of the sectors; indeed, the equity market implications are not that shareholder friendly.

Stagflation fears regarding financial market investments may be overdone. The idea that stock and bond markets may be poor performers during short bursts of so-called "stagflation" may be more myth than fact, given historical study, while alleged investing in commodity-based protection seems equally unsound. (Citigroup Research, June 23)

Liz Ann Sonders, Charles Schwab

Housing seems to have taken a bit of a back seat to inflationary concerns and escalating energy prices, but we continue to think housing is key to future U.S. economic activity due to its prevalence in most Americans' lives. Unfortunately, this key doesn't look to be improving in the near future as foreclosures continue to rise, pushing inventories of houses for sale to an all-time high of 11.2 months (at today's sales pace, it would take that long to liquidate current supply). (Charles Schwab Market Perspective, June 20)

Ed Yardeni, Yardeni Research

The Fed is constantly fine-tuning monetary policy with the goal of achieving an economic utopia of low unemployment and low inflation. The word utopia is derived from the Greek and means nowhere. That's just about where the economy is right now. It's probably in a shallow recession, with the jobless rate recently rising to 5.5% in May, the highest since October 2004. It has an inflation problem led by fuel and food prices, but core inflation remains remarkably subdued. Some economists put it all together and say that the economy is experiencing stagflation. The grim reapers among them believe that the Fed will have no choice but to fight inflation and push the economy into a long and deep recession. I'm in the purgatory camp. (Yardeni Research Morning Briefing, June 26)