http://www.theglobeandmail.com/globe-investor/investment-ideas/experts-podium/an-unbelievable-recovery-is-just-that/article1731191/

Optimism is running high in the U.S. stock market. Bulls now have the upper hand and are arguing that stocks provide a one-way ticket up.

Their agruement is that if the economy does expand, the stock market will enjoy the fruits of stronger earnings growth. If the economy sputters, the Federal Reserve will step in and embark on more quantitative easing (QE) – a policy in which it prints money to buy long-term bonds, thereby driving down interest rates and bolstering stock prices.

My view is considerably more restrained. I believe that bulls are missing the possibility that the economy will weaken to such an extent that the Fed does indeed re-engage in quantitative easing, but it doesn’t work.

After all, the Fed’s first round of QE last year didn’t work. If it had, the Fed would not be openly contemplating a second round.

Despite last year’s QE program, the Fed has cut its growth estimate twice in the past three months and has sliced its inflation forecast three times. Normally, the pace of economic activity is accelerating to over a 5 per cent annual rate in the second year of recovery, not slowing down to below 2 per cent – especially with all the monetary, fiscal and bailout stimulus that is in the system.

Here’s the bottom line: If not for the stimulus and the inventory swing, the U.S. economy would have actually contracted this year.

Another round of QE might provide temporary relief, but there is little reason to conclude that it will be successful in terms of giving the economy a sustained boost. Among other problems, it has to overcome the lingering trauma on baby boomers’ balance sheet– the average U.S. household has lost more than $100,000 (U.S.) in net worth over the past three years. There is also Japan’s experience to consider. It tried QE in the 1990s, but with only limited success.

The bulls argue that it is impossible to have a double-dip recession at this juncture since one has never happened in the past under circumstances like the present. That is a dangerous assumption to make – just like it was a dangerous assumption to say that home prices cannot go down because they never have in the past.

Be Very Afraid

Investors should play this market very gingerly. The profit share of GDP is back to a cyclical high, so this is no longer a case where modest low-single-digit economic growth delivers a double-digit earnings stream. In my view, assuming moderate buybacks, revenues that grow in line with GDP, and pressure on profit margins, corporate earnings will be, at best, flat for the coming year.

Analysts are already cutting their earnings estimates. They have reduced their profit forecasts on 521 companies in the past four weeks while increasing them on just 391 stocks. According to CIBC World Markets, over 60 per cent of 2010 earnings revisions have been to the downside in recent weeks, the highest ratio so far this year, and more companies are reducing their guidance for future earnings rather than lifting it.

The tremendous government stimulus and huge inventory swing that propelled the economy last year are set to the run their course. There is at least 1.5 percentage points of fiscal drag coming next year at a time when inventories will likely no longer contribute to GDP growth. Real final sales are growing at less than a 1 per cent annual rate. This is all a prescription for an economic contraction, not expansion.

I would be much more convinced about the case for a sustained bull market in equities if the consensus forecast for S&P 500 profits were closer to $70 or $80 a share for next year, rather than the current $95 forecast, which assumes either a vigorous surge in nominal GDP or profit margins expanding to new record highs.

I would not advise putting big bets on either of these developments taking place. There was a reason why the National Bureau of Economic Research declared the end of the recession, but did so in a statement laden with caveats and with nothing to say about the contours of this recovery. We will look back at the current depressed levels of the U.S. housing market and low consumer sentiment and wonder how it was that anyone could have believed a sustained recovery had begun with all of these metrics at levels consistent with recessions, not expansions.