Clouds on the Horizon?

I've been working on my quarterly/year-end letter to clients.

While I remain positive on the near-term outlook for the stock market, I am worried that my positive outlook seems to be squarely in the consensus, which usually is trouble.

I turned bullish on stocks in September, which turned out to be a pretty good call (believe me, not all of my forecasts have been so prescient). However, where my call in early fall was solidly non-consensus, now it seems that bullish sentiment is considerably more widespread.

For example, not a single Wall Street strategist - not one - is predicting a down year for stocks in 2011. Mutual fund flows into domestic equity funds are turning positive for the first time in many months. The media is full of confident predictions that 2011 will be the third strong year in a row for U.S. stock markets.

Many of the factors that have been helping global markets remain intact. Fed policy remains extremely supportive of capital markets. Valuations are not unreasonable. Corporate cash levels are ridiculously high, which probably means a wave of M&A activity in the next few months. With interest rates so low, a reluctant public will be forced to move off the sidelines and invest in stocks, especially dividend-paying stocks.

So far, so good.

However, with bullish sentiment so widespread, when will all of the "good news" be priced into the market?

Moreover, while there is no denying that the economic data recently has been positive, it is not clear just how much of the recovery has been fueled by a combination of fiscal/monetary stimulus that at some point will be pulled.

Here's an excerpt from an article from The Economist which does a good job capturing this:

That leads to another potential flashpoint for 2011: the lack of global co-ordination. Gone is the consensus seen at the G20 meeting in April 2009. Europe will be pursuing austerity, China is trying to rein in bank lending but America has opted for another fiscal stimulus. This is a throwback to pre-crisis 2007, with American deficit-financed consumption set against Chinese surplus-creating exports.

It seems certain that the Federal Reserve will continue to accompany fiscal stimulus with the monetary equivalent in the form of near-zero interest rates and further quantitative easing. The need for such extraordinary measures is an indication of how weak the economy continues to be. But while the developed world is still fighting off deflation, the developing world is worrying about inflationary pressures, with gold near $1,400 an ounce and oil back above $90 a barrel.

Buttonwood: In a spin | The Economist

I think that you have to stay invested in stocks at this time: the old adage of "Don't Fight the Fed" should be every investor's mantra.

But I suspect in a few months, as cries for cutting fiscal spending are realized, and the Fed is forced to gradually move to the sidelines, stocks might be, shall we say, challenged.