I am not a long term trader and do not hold a very strong conviction on long term views but I do think short term traders should understand how the longer term investors might be positioning themselves. Here are my thoughts on the possible scenarios that might play out in the economy and the market through the end of the year.
At this stage you have an economy which is moderately growing with a moderate level of job growth. The amount of monetary stimulus is very high. Fiscal stimulus is fading slowly.
Going forward over the next few months there is a high likelihood that monetary stimulus will start receding with the end of QE2. Fiscally also there will be more headwinds as the focus shifts to spending cuts and maybe even tax increases down the road.
Under these circumstance I can see 2 major scenarios playing out.
1. The current organic momentum in the economy is not strong enough to encounter the end of stimulus and a minor correction in the stock market leads to a full fledged bear market and a strong slowdown in GDP by the end of the year. Under this scenario we might have already seen or will see the high of the year within the next few weeks and then keep going down for most of the year and end somewhere between 1000-1100 in the s&p 500.
2. The second scenario is that the organic momentum in the economy is strong enough to keep growth going. In this scenario, I think we will still see a correction in the market during the summer (due to high uncertainty of what happens in the economy after QE2), but when the market sees that the economy and job growth are still holding up, the market will mount a strong rally and end the year around 1400 in the s&p 500.
At this stage I am leaning more towards the second more bullish scenario. The main reason is that I think once job creation starts in an economy it does not reverse unless there are some major inefficiencies in the economy. At this stage I think the economy is running very lean and corporate profitability is very high. We might see some shrinkage in corporate profit margins but that does not mean job growth cannot continue. When you look at longer term unemployment charts you can see that once it drops from a peak the unemployment rate keeps dropping for some time, it does not reverse and hit a new peak very fast. If you look at the graph below we have turned down from a significant peak and it does look like the rate will keep dropping for some more time. Therefore I think due to continuing job growth the economy should be able to manage moderate GDP growth.