Moving on From Mr. In-Between

The late Johnny Mercer was on to something about the markets, whether he knew it or not. Investors are trying desperately to heed his instructions: Accentuate the positive, eliminate the negative and don’t mess with Mr. In-Between.

The sentiment in those lyrics captures the tug of war between today's bulls and bears. The recession is over, but recovery is halting, jerky and largely dependent on government stimulus. Though there's broad consensus that the worst has passed, forecasters' worries now center on inflation, unemployment and consumer spending. Is the rally sustainable? Are earnings surprises coming from deep cost cuts or rising sales? It's not clear, and that's what makes this recovery a puzzle.

Joseph Pellegrini, of Robert W. Baird's consumer and retail analyst team, summed up the conundrum in his October Outlook: "We view a binary classification of the economic environment as 'recession' or 'recovery' as too limiting in the current case given the connotations associated with such words. In the past, when recovery quickly followed recession, this economic intermezzo mattered little because it was so brief. Now, however, it appears to have morphed into a movement of its own, with themes and variations that merit discussion and analysis."

As third-quarter earnings roll in, mostly on the positive side, there's plenty of discussion and analysis. At the core of it all is the government's role in recovery. "With the micro and macro news generally positive, in our view, the only remaining question as to whether the rally will continue is Fed liquidity," Barclays Capital strategist Barry Knapp wrote in an Oct. 16 note. He points out that, since the September FOMC meeting, the Fed has slowed its purchases of agency mortgage-backed securities – funding their debt, essentially – from $25 billion per week to $20 billion a week. With total fixed-income supply expected to increase from $975 billion in 2009 to $2.128 trillion in 2010, and the bulk of the supply in the Treasury market, "without Fed buying, this should be interesting,” he wrote. “One of our core views is that monetary policy is a blunt instrument, and there are always unintended consequences of aggressive policy moves."

Inflation if often a result of big government spending binges, and although it's not here yet, it's remains a concern. "Early in a recovery, interest rates and inflation tend to move in the same direction," Morgan Keegan economist Donald Ratajczak said in an Oct. 19 note. That should go on for the first quarter of the business cycle, but "certainly by next summer, long rates will be significantly higher than they are today."

For now, the hope is for more signs of economic recovery through the rest of this earnings season and the end of the year. Data gleaned by ISI Group's Ed Hyman offer "a reasonably solid, but complex economic outlook," with stronger chain-store sales, declining unemployment claims and international trade recovering quickly.

"So far, profits have been boosted by cost cutting," he wrote Thursday. "Now an unprecedented synchronized global upturn is lifting profits by strengthening earnings of domestic companies and both sales and earnings for U.S. multinationals. In addition, profits are being lifted by the declining dollar via both foreign earnings of U.S. multinationals and U.S. trade improving."

Although we might reap those benefits, Americans may need to grow accustomed to not setting the economic pace for a while, wrote economist Ed Yardeni of Yardeni Research.

"The resumption of the Greatest Global Boom of All Times could certainly do the trick," he wrote Thrusday, employing a favorite phrase in his reports. "It started on Dec. 11, 2001, when China joined the World Trade Organization. It was interrupted over the past couple of years by the collapse of the credit insurance fraud industry. But now it seems to be gaining traction again. While there might be a protracted period of economic stagnation for the billion people in the Old World (Japan, the U.S., and Western Europe), there are two to three billion people in the New World who want to prosper."

After all, "Ac-Cent-Tchu-Ate the Positive," released in 1944, was a global hit for years.