Spelling Out Risks With a W and 4 E's

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.

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