Where Do We Go From Here?

When you’re as bearish on the stock market as Dan Cook, you hear countless arguments about why it’s time to jump back in. The recession is ending. The government’s attempt to fix the banks is working. The rate of job losses is slowing down. Blah, blah, blah. Cook doesn’t believe any of it. As the senior markets analyst with global investment and trading house IG Markets, Cook, 37, advises institutions and wealthy people about what to do with their money. Forget about all the sunny forecasts that came with the spring rally. His most recent outlook is more like a storm warning: The stock market is “in the eye of the hurricane and the clouds are closing in again.”

In a year that has seen stocks fall 20 percent in nine weeks, only to recover all of that and bounce way above the lows in the following weeks, it’s no surprise that investors are having a hard time figuring out what to do. And they’re not alone; professional investors are equally torn. More than 42 percent of fund managers in a recent survey believed stocks were undervalued, according to Merrill Lynch, yet nearly the same percentage of pros were underweighted in stocks and disproportionately invested in bonds or cash. The rally coaxed some managers to step up and buy, but a significant number remained on the sidelines, seemingly afraid to get back in.

From his office just outside Chicago’s Loop, Cook discounts the market’s rebound for one main reason: He thinks the nation’s banks are still in trouble. For the past year Cook’s daily notes to his firm’s 70,000 clients—many of whom are foreign-currency and options traders—have been filled with warnings about the outlook for the U.S. stock market. At one point, he even apologized for exhausting all the synonyms he knew for the word dire. “There are only so many ways to say that the global economy stinks,” he wrote.

But 350 miles east on Interstate-80, another Midwest market guru takes the opposite view. Bruce McCain, chief investment strategist at Cleveland-based Key Private Bank, is convinced the recovery is for real. McCain, 55, had been a stock skeptic since 2000, worrying that equity prices were too high then and never got low enough to be considered bargains. Even during the rally from 2003 to 2007, he cautioned clients to be less aggressive with stocks. His reticence spared those who took his advice the worst of the market crash. But these days he’s telling the people who have given Key Private Bank $22 billion to invest that he’s buying stocks, both here and abroad. As the economy shows early signs of improvement, McCain says the risks of not being in the market now outweigh the risk of being too aggressive.

So who’s right? The bear or the bull? SmartMoney checked in with both to hear their best arguments. What they had to say helps sum up a debate now taking place in trading pits and investment committee meetings around the world.

SmartMoney: Let’s start with the obvious question, Bruce. Why are you bullish?

Bruce McCain: We’ve seen a fairly typical market bottoming process, lows in October and a test of those bottoms in March. What we’ve seen more recently are a variety of economic statistics, particularly leading statistics, showing major signs of stabilization in the economy. The market psychology has shifted away from outright panic to looking for a recovery and even feeling that if you don’t invest now, you’re missing out. With the odds of hitting a new low relatively low, we feel we can get out front on this.

SM: Dan, you aren’t convinced.

Dan Cook: When I look at the rally we’ve had, I want to inspect the foundation, and in the foundation we have some cracks. The spring rally was sparked by [Treasury Secretary] Timothy Geithner’s Public-Private Investment Program, the PPIP. There are still a whole lot of unanswered questions about how it will work. The Treasury also has thrown $1 trillion of liquidity into the system. We’re seeing that die out. Until the banks really recover, we won’t have a whole recovery.

SM: Bruce, even though you’re bullish, you still expect the market could pull back at some point?

BM: Yes, we’re looking for a pullback. The question is, how much. Since I think we’ve turned the corner on investor psychology, a 5 to 10 percent pullback is something I’d look for, as opposed to a much deeper dive.

SM: Dan?

DC: I think we could still see the stock market rally in the short term. However, the bigger issue is employment.

SM: Why’s that?

DC: Without a job, it’s difficult to pay the bills. When there’s no job, there’s less spending, and less spending means less corporate profits and no reason for the market to keep going higher.

SM: What indicators are you following that lead to your bearish outlook?

DC: In addition to employment, I’m looking at the bank reports, not just the headlines that say they’re profitable. I want to know why they’re profitable. At least in the first quarter, it’s been because they are doing a lot of mortgage refinancing business. That won’t last.

BM: We’re big believers that the markets are one of the best indicators of the economy. It’s not just what the averages are doing either. We look at where investors are putting their dollars—technology stocks, consumer discretionary stocks and other stocks that do well when the economy is turning for the better. We also look at leading indicators like initial jobless claims. They still don’t look good, more jobs are being lost, but you see that the rate of change is not as extreme as it was a few months ago.

SM: Do you think we’ve made progress on resolving the banking crisis?

DC: We’ve seen credit spreads [interest rate differences] between Treasury bonds and corporate bonds get closer. That’s a positive. But they’re still wider than you would see in a “normal” lending scenario. And there’s still no credit. Banks are killing a lot of credit to good people because they don’t know who will have a job from one month to the next.

BM: That’s a deep question. At least with the banks, it’s the devil you know. The problems with the banks are, at least, largely knowable. Since there are some indications that the housing market is beginning to shore up, we might have also seen the worst of it in the banks.

SM: If someone gave you $10,000 in cash to invest right now, where would you put it?

BM: We’d definitely be moving out of a defensive posture and into areas that benefit from a growing economy. So we’d put some into commodities and emerging markets. We also would put some into basic industries and technology, too.

DC: If I had to put it in the stock market, I’d look at companies that are going to be around, a name like Johnson & Johnson. It won’t be a huge grower, but I still want to be defensive. J&J won’t have a bad return over a few years. I do think the dollar will rally. In fact, the U.S. dollar will be stronger against most every currency with the exception of the yen, to the chagrin of the Japanese economy.

SM: What about in fixed income such as bonds?

BM: We’re pretty skeptical that you can make money from Treasurys. They’ve been a good place to be defensive, but if you look out into the future, the biggest concern is that the government makes a mistake, leaving too much liquidity in the system and fueling inflation. So if you wanted fixed income, we’d put it only in inflation-protected securities.

SM: Dan, is there anything that makes you hopeful?

DC: Some of the things we’ve put in place, like guaranteeing commercial paper, keeping interest rates low and other things will work potentially faster than I expect. If I see debt defaults and unemployment start to stabilize, then I’ll be sold. I just don’t think we’ll be creating jobs anytime soon. Those “green shoots” people say they see in the economy, I don’t see those.

SM: Bruce, what worries you?

BM: It’s not hard for me to flip and take the other side. Our biggest concern is what sorts of policy shifts are coming from Washington. We’re talking about pretty radical things, like taxing carbon use. We could push many businesses beyond the breaking point.

SM: Do you not like what the Fed has been doing?

BM: The Fed has done a pretty good job providing us with liquidity. However, can they remove that liquidity fast enough to avoid big inflation? On the fiscal side, we have some real concerns that Washington is pushing the limits on what the economy can bear, the massive amounts of spending.

DC: I’m in agreement with Bruce about the Fed. I’d like to see a little more of an exit strategy, like how they will withdraw all the liquidity. And we haven’t addressed all the issues, like monitoring companies that might pose a systemic risk to the financial system.

SM: Have either of you ever experienced a market like this, with a big crash followed by a sharp rebound?

BM: The last time something like this occurred was in 1974. I wasn’t actively involved in the securities industry at that point—I was in college.

DC: Yes, you’d have to go back definitely to the 1970s for a parallel to today’s market. Back then I would have still been home watching The Match Game with my mom.