Stocks continue to celebrate the survival of the global financial system. The change in investor sentiment has been dramatic. As recently as early March, the market was deeply troubled that the banking system and the worldwide economy may be grinding to a halt. But in the few months since, this Armageddon view has been swiftly replaced by euphoria that the global financial system will not only survive but may be poised to thrive once again. This dramatic shift in sentiment along with initial signs of stabilization in the global economy and improvement in the credit markets have helped stocks explode +40% higher from the bottom in early March. But while the recent rally has been intoxicating, the investment environment is likely to become more sobering from here with a mounting valuation headwind as a major constraint.

The current rally is showing some signs of fatigue. The stock market as measured by the S&P 500 reached a closing bottom on March 9 at 677 and has rallied nearly +40% through June 9. Dissecting the path of this rally, a large percentage of the gains were registered in the first stage as would be expected. From its closing low on March 9 to March 26, stocks gained +23%. In the weeks since March 26, stocks extended their rally but at a slower pace. By May 8, stocks tacked on another +12% and were up +37% overall from their March 9 lows. But in the weeks since May 8, the pace of the rally has diminished considerably. Despite setting a new high on June 2, stocks have been choppy along the way in gaining just +1% from May 8 to June 9. This most recent stage of the rally has also included several retests of the previous May 8 peak in recent days. So although the media conversation about the current rally remains enthusiastic, underlying stock performance is becoming far more measured.

The stock market rally since early March has been impressive, but only on the surface. Since the market bottom on March 9, stocks as measured by the S&P 500 have rallied nearly +30% through the end of April. This has understandably raised hopes that the worst is now behind us and a sustained long-term rally is fully taking hold. Unfortunately, a closer look suggests that investors are likely to grapple with more downside in the months ahead before the current bear market is finally over.

Investors are potentially standing on the precipice of another Great Depression. Conventional wisdom has long held that the Great Depression would not happen again. Behind this notion was the belief that much was learned from the mistakes made during this difficult period in history and policy makers would know how best to intervene to keep the economy from tumbling back into another abyss. But this conviction is now being put to the test after three-quarters of a century, as the events that are unfolding today have some alarming similarities to the Great Depression of the 1930s. As a result, it is worthwhile to consider how one might best navigate an investment portfolio through such a treacherous market backdrop.

The causes of the Great Depression were not necessarily so clear-cut. For decades, economists were broadly divided over the events and actions that led to the financial collapse of the 1930s. It was not until recent years that a consensus view began to form behind the research of leading experts on the subject, including Federal Reserve Chairman Ben Bernanke. The fact that it took some of the world’s top academic minds over fifty years to begin developing a cohesive explanation for the Great Depression indicates the deep complexity of this past crisis. But more importantly, it also suggests how challenging it may be working in real time to prevent a similar outcome today given the completely new set of driving circumstances and fundamental risks, some of which may not be well understood or even recognized by policy makers at the present time.

The 2008 presidential election is heading down the home stretch. After a long and historic primary season, the nominees for both major parties are now in place and the general election season is about to get into full swing. With a new President set to be elected on November 4, many investors are actively debating which candidate will be best for the stock market. Fortunately, recent history serves as a useful guide to determine whether an Obama or McCain presidency might be better for investment markets over the next four years. Unfortunately, the results may prove unsatisfying for those voters seeking a decisive difference.

Since World War II, the presidency has been generally split between the two parties. Eleven Presidents have served in office over the last 63 years since the end of World War II. Democrats including Harry Truman, John Kennedy, Lyndon Johnson, Jimmy Carter and Bill Clinton held office for a total of 27 years, or 43% of the time. On the GOP side, Dwight Eisenhower, Richard Nixon, Gerald Ford, Ronald Reagan, George H.W. Bush and George W. Bush all served as President for a total of 36 years, or 57% of the time.

Investor nerves are running high. It is a question that seems to arise with more frequency during times such as these. “With the market moving lower day after day, should I pull my money out of the market?” While the urge to flee the market is certainly understandable, it is typically not the best move to exit in the midst of a prolonged decline. Even if you have decided that you’ve had enough of the market volatility and need to head to the sidelines, showing some patience before executing such a move is typically rewarded.

Bear markets do not move lower in a straight line. Although it may feel this way when you’re going through it, bear markets instead move lower in a series of steep declines followed by sharp rallies. For example, although the current bear market is now down over –20% from its October 2007 peak, it has been anything but a straight path down to arrive at this point (see chart). Instead, the market has had an up and down ride along the way including five corrections ranging from –5% to –15% and four rallies ranging from +4% to +12%.

The bond market appears sanguine about the inflation outlook. In my recent article Inflation Fears Are Overblown, I discussed how inflation pressures across the economy are largely under control. I also indicated how many disinflationary and deflationary forces were also at work that should cause lingering pricing pressures to subside in the months ahead. Based on the data, it appears that the bond market generally shares this view.

The bond market is typically very sensitive to any signs of inflation. While it is certainly an issue for stock investors, the threat of inflation is a paramount concern for the bond market. This is due to the fact that rising inflation erodes the value of the fixed income coupon payment provided by bonds. As a result, bond investors watch inflation signals very closely and will reacting swiftly by selling bonds given a mere whiff of prolonged inflation pressures.

History often repeats itself in the stock market. Over time, the stock market has demonstrated the tendency to respond to recurring economic and market conditions in a strikingly similar way. For example, the factors affecting market today bear a meaningful resemblance to the conditions facing stocks back in 1990. And the market’s response in both instances has been uncannily similar. But while history can provide a surprisingly useful road map in anticipating future market movements, the correlations are never perfect from one episode to the next, as unexpected surprises often surface along the way.

The market backdrop in 1990 and today are similar in many ways. Back in 1990, the banking system was in crisis and the economy was trending toward recession. The primary driver of the economic slowdown at the time was a deterioration in consumer spending and a sharp rise in oil prices following the Iraqi invasion of Kuwait. Unemployment was rising and corporate earnings growth was decelerating. All of these elements could easily be used to describe the current environment for the stock market today. And the response of the stock market in both episodes up until recently has been equally similar (see chart). From the 90 trading days prior to the market bottom in October 1990 and March 2008 to the 60 trading days following these lows, the stock market as measured by the S&P 500 has taken a near identical path. However, it appears that in recent days the market may have decided to split off on a new route.

Inflation fears have been weighing heavily on investment markets. At first glance, these concerns seem well founded. After all, prices for gasoline at the pump and food at the grocery store have skyrocketed. The chronically weak U.S. dollar is also adding fuel to the fire, as it makes the cost of imported goods more expensive. And the U.S. Federal Reserve has pitched in too by lowering interest rates aggressively over the last year from 5.25% to 2.00% in response to the weakening economy and the global credit crisis, as these rates cuts are working to put more money in the hands of businesses and consumers to help increase their demand to buy new products. Despite these influences, a closer examination of the situation reveals that the inflation threat to the U.S. economy is actually fairly limited at present, which should eventually be good news for both equity and fixed income investors going forward.

The inflation problem is far more concentrated than it first appears. Looking beyond food and energy, the rate of increase in prices across the broader economy is actually rather subdued. In addition, many segments are actually enduring an extended bout of deflation. For example, many furniture and clothing retailers have been offering fairly aggressively discounts in order to move merchandise from their stores. And one can go out today and purchase a new car for less than what they paid for a comparable new model back in 2003. So while some items we are buying today are significantly more expensive, other items are actually becoming meaningfully less expensive.

Oil prices continue to soar. The oil price boom over the last several years shows no signs of stopping. While oil traded below $20 per barrel as recently as 2002, oil prices have skyrocketed over the last 5+ years to reach levels above $130 per barrel. This represents a +500% increase in oil prices and helps to explain why prices at the gas pump have risen so sharply in recent years.

Fundamentals suggest oil prices may rise further in the years ahead. While some on Wall Street might believe that oil prices are unrealistically high and will eventually come back down, the underlying fundamentals suggest otherwise. First, existing oil supplies are limited and the potential for adding new oil supplies is gradually diminishing over time. Second, demand for oil remains strong and continues to rise, particularly from emerging economies such as China and India. Third, global oil drilling and refining infrastructure is aged and deteriorating, resulting in oil production breakdowns and supply bottlenecks. Finally, a meaningful percentage of the world's oil is sourced from politically unstable regions leading to periodic and unexpected supply disruptions. Thus, while short-term oil price corrections should be expected along the way, all of these factors support a higher long-term trend for oil prices.