Global stock markets rallied sharply in July—capping the best five-month run in stock prices since 1938—and have broken out to new bull market highs. Markets have priced in an end to the Great Recession, as evidence of economic stabilization has accumulated. With the S&P 500 up 50% since the panic lows of early March, the “easy money” in the financial markets has been made, and now it is the trajectory and substance of the eco­nomic recovery that will be the greatest determinant of stock market returns. Thanks in large part to the ultra-expansionary fiscal and monetary policies that have been implemented globally, the economy appears set to recover—for awhile.

But a self-sustaining recovery needs more than just government stimulus and inventory replenishment; it requires a reinforcing cycle of increas­ing consumer spending and incomes, and there is no evidence yet of that. Indeed, U.S. consumers are still reeling from the combination of (1) a doubling of the unemployment rate from 4.8% to 9.5% in just 16 months; and (2) a large negative wealth shock of ap­proximately $15 trillion since early 2007 due to the bear market in housing and financial assets. Moreover, rela­tive to incomes, U.S. household debt levels are still 30% higher than the average levels of the 1990s. The best-case scenario, as far as the U.S. economy is concerned, is that deleveraging in the household sector plays out over a number of years, with consumers continuing to spend (more modestly) and gradually paying down debt at the same time.

This bull market is only five months old, and should be given the benefit of the doubt, but investors should be mindful that as prices move higher, the risk/reward deteriorates, since price is inversely related to value. It is more likely than not that the stock market still has significant (i.e., 15% to 20%) upside potential over a 12-month time horizon, but that potential now comes with realistic downside risk of similar magni­tude. Investors should be especially careful with re­spect to the timing of any new purchases, given that stocks are stretched to the upside on a short-term basis and are close to a potentially important resistance level of 1000-1025 on the S&P 500. In addition, the sentiment backdrop has shifted from being a strong positive to a slight negative. Sentiment indicators are not yet flashing serious warning signals, but there are signs of complacency entering the market, which is another reason for caution.

According to a composite of indicators tracked by SentimenTrader, a research service that provides comprehensive analysis of inves­tor psychology, 63% of retail investors are now bull­ish, compared with only 20% at the pessimistic ex­tremes in early March. Similarly, the percentage of bearish respondents in the most recent weekly survey from the American Association of Individual Investors has fallen to 31%, the lowest reading since May 2008. In this environment, with so many unpredictable forces in play, and with no close historical analogue, no one should be overconfident about anything and investors should retain a healthy respect for risk.

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