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Stocks have lost some ground lately after making new multi-year highs in early October. The optimists are spinning the market's loss of momentum as nothing more than a brief consolidation phase, which they view as a healthy development given the rapid gains from the summer lows.
The other side is far less sanguine about what's happening in the market at present and sees this as a sign of things to come, particularly given the sub-par corporate earnings picture and other macro challenges coming the market's way.
These contrasting views beg the question of where we go from here. And that's my goal in this piece - to survey the landscape of bullish and bearish arguments to help you make up your own mind.
Towards the end, I will share a robust investment framework that you can rely on irrespective of whether you lean more to the bullish side or otherwise.
Let's talk about the Bull case first:
1) The Negatives Are Already Priced In: This means that the sum total of all bad or negative news about the U.S. and global economy is already well known and reflected in current prices. It seems quite plausible since questions about the U.S. economic outlook, concerns about the Euro-zone's future and China's growth trajectory have been around for a while now and are no longer 'news' to any market participant.
2) Economic & Earnings Pictures Quite Healthy: A host of recent economic data, including last week's GDP report, show that the Spring/Summer weakness is dissipating. The country's housing market also appears to be showing signs of life. With respect to corporate earnings, the third quarter reporting season has been on the weak side, but the positive outlook for the fourth quarter and beyond belies fears of an imminent collapse. In fact, earnings for the S&P 500 are expected to be up nicely next year, hardly a worrisome backdrop.
3) Central Bank 'Put': The monetary policy stance across all the major economies from the U.S. Federal Reserve and the ECB to China's central bank remains favorable and supportive of the market. What this means is that market participants can continue to expect the Fed and other central banks to stand behind them should they need help in the coming days.
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Let's see what the Bears have to say in response:
1) The Market Is Pricing a Best-Case Scenario: Market prices reflect consensus expectations, and current consensus expectations for GDP and earnings growth are clearly on the optimistic side. The same goes for Europe, where the best that an ECB expansionary policy would do is to reduce the odds of major turmoil in Spain (Italy), but will do little to stop the region from moving into a deep recession. It is way too optimistic to assume that the U.S. economy and corporate sector will remain immune from the negative forces swirling all around.
2) Economic & Earnings Pictures Far from Healthy: While a couple of economic indicators appear to have turned positive in recent days, the overall trend has been less than reassuring. Even if the looming Fiscal Cliff issue is adequately addressed, the U.S. economy is on an unmistakable decelerating trend, notwithstanding the tentative signs of housing improvement. On the earnings front, don't let the positive earnings outlook for the fourth quarter and beyond distract you from the fact that the picture is hardly in good shape. Weak guidance from management teams has started bringing down expectations for the coming quarters, but they remain way too optimistic. Earnings growth was a key prop for this market since 2009, but it will likely have to navigate without this support going forward.
3) The Fed Is Irrelevant: While supportive action from the European Central Bank and China could be very helpful, the same can't be said about the U.S. Fed, which seems to have run out of options after its open-ended QE3 program. The ECB plan announced some time back appears to have pulled back Spain (and Italy) from the brink and given the union leaders more breathing room. But the plan's onerous conditions, largely a function of Germany's dogmatic stance, are coming in the way of Spain wholeheartedly adopting it. That said, it is nevertheless a net positive.
Where Do I Stand?
As regular readers know, the bearish case makes more sense to me than the alternative. Simply put, I find it hard to envision stocks holding their ground. And I expect this trend to continue for some time, at least through the remainder of this year. The picture is expected to be a lot clearer beyond the next 6 to 9 months, as we get more clarity on the issues facing the market at present.
But being bearish doesn't mean that you have to exit the market. I remain fully invested and cautious against the risks of market timing. That said, it makes perfect sense to position your portfolio for a period of above-average downside risk. To that end, I advocate greater exposure to defensive and non-cyclical industries and look for dividend payers with solid earnings growth profiles. To pick such stocks, I rely primarily on the Zacks Rank, which helps me capture the essence of earnings momentum in any industry. Whether you are bullish or bearish in your near-term outlook, you move the odds in your favor by relying on the disciplined stock selection framework of the Zacks Rank.
Something to Keep in Mind
At Zacks, we don't ask our strategists and commentators to follow an official line on the market. This policy of letting a thousand flowers bloom means that my bearish view is just one amongst many.
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Sheraz is the Director of Research at Zacks Investment Research where he relies on access to valuable data to assess winning stocks and funds. Now he invites you to use Zacks Confidential to explore selected recommendations from our team of experts.