I am relatively sanguine regarding the U.S. equity market (^SPX, ^DJIA, ^IXIC) when viewed from a long-term perspective. However, as detailed in my latest article, I currently have a negative outlook regarding equities in the next 8-10 weeks.
There are essentially three things that could cause me to become either neutral or bullish on equities during this span of time.
Pro-Active European Policy
Europe is a disaster waiting to detonate at any moment. Having said that, the means for putting a halt to the crisis is clear: The ECB must aggressively intervene by announcing that it will buy an unlimited quantity of the sovereign debt of member nations that are complying with pre-established fiscal targets in order to keep interest rates at reasonable levels.
Unfortunately, there is no consensus within Europe to implement this policy or any other policy that could effectively halt the downward spiral and negative feedback loop between sovereign bond markets and European economic activity.
If this situation were to change and European officials demonstrated that they have a plan to contain the crisis, and that they have the resolve necessary to implement aggressive solutions, I would become more constructive on global equity markets.
Until then, the downward spiral in Europe continues unabated and is proceeding at an accelerating rate.
Pro-Active Fed Policy
The U.S. economy is clearly decelerating. The Fed needs to act decisively to halt this deterioration before the economy slows below the level of “stall” speed. Various tools are available to the Fed that could provide a positive jolt to the economy.
Unfortunately, there does not appear to be consensus within the Fed for the sort of aggressive action that would be required in order to provide meaningful stimulus.
As long as the Fed remains reactive rather than pro-active, the threat of recession will loom large and exert a negative impact on the equity market.
A Positive Surprise From The Super-Committee
Virtually nobody is expecting anything positive to come out of the Congressional Super-Committee charged with coming up with a proposal to reduce the long-term fiscal deficit of the U.S.
Ironically, this pessimism is a potential source of upside for global markets: It sets up the possibility of a substantial upside surprise.
Such a prospect is not far-fetched. The outlines of a potentially significant breakthrough were almost agreed to by President Obama and Speaker Boehner in July. This scuttled attempt at an agreement would have reduced the long-term deficit by $4 trillion. By contrast, the current mandate of the Super-Committee is only to find $1.5 trillion (at least) in deficit reduction.
It does not require a large leap of the imagination to suppose that the one member of the Super-Committee might step across party lines to agree to a reasonable compromise such as that which was almost agreed to between Obama and Boehner.
A deficit reduction plan of $4 trillion versus the $1.5 trillion that is currently expected to emerge could electrify global markets as it would largely eliminate a major perceived threat to global economic stability.
A Shift In Sentiment Could Activate Pent-Up Demand
The current slowdown in the U.S. economy is being driven by a deterioration of consumer and business sentiment. The debt ceiling crisis in the U.S., the U.S. sovereign debt downgrade, and the multi-faceted economic and financial crisis in Europe have constituted severe shocks to business and consumer sentiment.
By the same token, a reversal of negative sentiment could have a powerful stimulative effect on the U.S. economy.
There are reasons to believe that a positive reversal of sentiment could lead to a meaningful economic improvement.
First, many consumers and businesses have postponed expenditure decisions due to the sentiment shocks referred to above. Consumers have postponed purchases of big-ticket items and businesses have postponed hiring and investment decisions. This implies that there is a certain level of pent-up demand in the economy. If sentiment were to improve, this pent-up demand could be unleashed.
Second, there is substantial pent-up demand associated with the disruption in supply lines caused by the disasters in Japan several months ago. As these supply line issues get worked out, inventory restocking and supply normalization could provide a boost to the economy.
What could catalyze a shift in sentiment that would be able to activate the various sources of pent-up demand in the economy? One need go no further than points 1-3 above.
The deep deterioration in business and consumer sentiment in recent weeks has mostly been caused by a perceived inability of policymakers in the U.S. and Europe to deal effectively with the economic challenges that are faced. A change in perceptions regarding the ability of policy-makers to propose and implement effective solutions could have an immediate positive effect on sentiment. This would translate into accelerated investment by businesses and spending by consumers.
Restoring confidence in macro-policy management is the most powerful source of stimulus that policymakers can possibly provide to the economies of Europe and the U.S.
An important psychological insight is that there is an innate tendency for humans to focus too much on what could go wrong. Given this tendency, it is important for investors to constantly make a conscious effort to imagine what could go right.
Problems tend to drive their own solutions. One should never forget that for every problem that exists, there are extremely talented individuals and organizations that are working very hard to solve those problems.
In the case of the macroeconomic challenges that face the U.S. and Europe, there a number of ways that a major crisis can be averted in the short term. No optimal solution to longer-term problems is possible in the context of an economic crisis. In the context of macro stability, viable solutions exist to place the U.S. and European economies on the right footing in the longer term.
Unfortunately, right now, the political wherewithal to implement the necessary solutions does not seem to exist. It seems that more short-term pain will be required before policy-makers are moved by necessity to enact serious solutions.
However, this can change. And I am prepared, at any moment, on sufficient evidence, to reverse my currently negative outlook for equities (SPY, DIA, QQQ) for the next 8-10 weeks. In the meantime I will be monitoring stocks such as Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Intel (NASDAQ:INTC), AT&T (NYSE:T), Verizon (NYSE:VZ) and even some financials such as Goldman Sachs (NYSE:GS). I believe that these stocks are already attractively priced when viewed from a long-term perspective. However, I believe that these stocks will ultimately be available for purchase at levels 15% to 25% below current prices.
Additional disclosure: I am short TLT and long TBT and SBND