What a difference three months makes. From the early March lows through June 1, broad stock indexes are up between 40% (S&P 500) and 65% (MSCI Emerging Markets). The price of oil has doubled from its first-quarter bottom, and yields on junk bond indexes have nearly been cut in half. The predominant worry has shifted from a debt deflation trap to a government-sponsored inflation problem. Investors have steadily renounced their extreme risk aversion and demand for safety. Equity, commodity, and credit markets are un­equivocally acting as though the credit crisis is over, and a new global economic recovery is on the way.

Apart from the typically strong initial rebound from a bear market bottom, two factors would seem to account for the extraordinary shift in the investment landscape over the past three months. First, the fear of financial and economic apocalypse was more intense than the vast majority of investors had ever before experienced. Since markets are a reflection of mass psychology, this led to a situation where sentiment became so negative and investment postures so defensive that risk assets had nowhere to go but up. Second, we have the exceptional circumstance of the greatest fiscal and monetary stimu­lus in history, and it is certainly working to revive global economic activity and asset prices. Ben Bernanke fa­mously said in 2002 that deflation is always reversible under a fiat (paper-based) money system. The surprise is not that he has been proven right, but that so many rejected his premise in the dark days of February and early March.

Few observers today doubt the ability of the Treas­ury and Fed to create inflation by widening the fed­eral deficit and expanding the monetary base in such an unprecedented fashion.

Now that we have had the powerful thrust off the lows, what happens next? Risk assets, especially in "high beta" asset classes like emerging markets and natural resources stocks, look very overbought. But a lot of investors—professional and non­professional alike—are still sitting on too much cash, and the pressure to get money invested in an environment where cash pays next to nothing, asset prices are moving up, and inflation expectations are rising, is intense.

While this bull market—only three months old—should be given the benefit of the doubt, the risk/return profile of stocks over the next couple of months appear neutral at best, given how much we have rallied from the lows. Within weeks, a mean­ingful correction will likely commence in stocks and other correlated markets, such as commodities, foreign currencies, higher risk bonds, etc. But the correction will probably be fairly shallow, retracing perhaps one-third of the gains since early March.

For investors who are holding too much cash rela­tive to their asset allocation targets, a patient, me­thodical approach to new buying should be em­ployed, especially in asset classes that have run up the most. It is still a very uncertain world, and there will undoubtedly be plenty of volatility in the months ahead, as opposed to the nearly straight line up that has occurred thus far.

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