Between a Bull and a Bear

Is it a bird? Is it a plane? Is it superman? Investors can't seem to figure out whether the recent leaps in stock prices represent a brief uptick in a falling market or something more meaningful, even the start of a brand-new bull run. The Pavlovian impulse is to dismiss the rally as just another head fake. After all, there have been five other countertrend moves since the bear market began in October 2007, and they all petered out within a couple of months as the fundamental

backdrop continued to deteriorate. Most analysts believe the economic mess has hardly been cleaned up: the American consumer is still deep in debt, housing inventories continue to mount across the world and green shoots are sprouting only because of massive government spending.

Herein lies the key. The trillions of dollars in spending programs can indeed stimulate the economy, at least for a few quarters, reviving growth this year. The broad consensus is that the U.S.-led global economy faces too many structural headwinds to enter a meaningful expansion phase, and that likely will be correct, but in the long term.

The current situation strongly echoes that of early 2003. Back then, most economists were of the view that parts of the U.S. economy were too indebted to allow for any significant recovery. However, policymakers including Fed chairman Alan Greenspan were not going to sit around and accept low growth after two decades of unbridled prosperity. Greenspan slashed interest rates, unleashing a housing-led consumer boom that ultimately resulted in a further buildup of debt in the system. With the consumer now a spent force, the only part of the economy that has the ability to take on any new debt is the government sector. So, policymakers will use that last growth option to the maximum extent possible.

Developed countries are expected to run a fiscal deficit of close to 10 percent of GDP on average in 2009. By next year, the government debt-to-GDP ratio in the United States will have reached levels not seen since World War II. In effect, the government is taking on debt from a private sector that's desperate to cut back its own highly leveraged position. Much like in Japan in the 1990s, debt is being swapped, not paid down or disposed; the only difference is that Japan's debt was concentrated in the corporate sector, while in the United States it is stacked up in the hands of consumers and financial firms.

The road map for the United States today is similar to that of Japan in the 1990s, but contrary to popular perception, that does not mean an unabated dip in stocks and the economy. Japanese stocks participated in some significant rallies during that decade, including three jumps of about 50 percent, all of which coincided with a temporary economic upturn. These recoveries—which are often described as cyclical bull markets within a structural downtrend—were triggered by government spending packages or export-led growth when the global economy was strong.

Similar conditions exist today, with the effects of the stimulus expected to be the strongest in the third and fourth quarters of this year. Growth in China, too, is showing strong signs of reviving. The market upswing is likely more substantive than a short-lived bear-market rally.

If that is the case, the S&P 500 could rise to 1000 sometime later this year. The rally could begin to fade by the end of 2009, once the impact of the stimulus begins to wear off. Any further headroom could be then limited by a general wariness about enacting any new spending plans, with government debt piling up and the binged-out consumer remaining in a funk.

The current rally could be cut even shorter if the bond markets begin to panic about the size of mounting government deficits that would crimp their ability to borrow, or if the financial sector and the consumer just want to get rid of the excessive debt at a pace faster than the government can spend the new stimulus funds.

The real wild card is the China-led emerging-markets growth story. It's possible that we could see a brand-new global bull market in stocks if China takes over America's place as the world's major economic growth engine. But the Chinese domestic market doesn't yet possess the scale or the size to play the same role in the global economy as the United States has so often done. China's share in the global economic output is 10 percent, compared with 25 percent for the United States.

Furthermore, domestic consumption in China constitutes an extremely low 40 percent of GDP, and while it is bound to increase in the coming years, such changes are gradual. For the time being, any revival in China is being led largely by public investment—even as its economy suffers from an overinvestment problem. China, too, will end this year with a high fiscal deficit of 6 percent of GDP, and while its situation is hardly as worrisome as that of its Western counterparts, there's a limit to how much it can spend to shore up the economy.

The conditions are not in place for a major new bull market to begin. But a bear market is not the only other alternative. There is a middle path, like Japan in the mid-1990s.