Investors would be wise to ignore the 'Goldilocks' recovery scenario

Despite last year's mauling, some high-profile Wall Street analysts see a "Goldilocks" scenario for the economy. That would be one where inflation remains subdued and growth picks up briskly. But investors should think twice before betting on such a fairy tale.

Following a wave of recent bullish data, including a better-than-expected employment report and strong retail sales, some powerhouse investment banks are now raising their growth forecasts for the year ahead. JPMorgan, Credit Suisse and Barclays Capital all now predict that GDP will expand at 4.5% in 2010. That's more than the upper range of 3.5% that even the Federal Reserve recently predicted -- and double the 2% growth scenario that bond giant Pimco has pushed as part of a broader lackluster outlook for the U.S. economy.

A strengthening economy could translate into an even higher stock market in the year ahead, despite the sharp gains racked up since last spring, some argue. The average forecast among nine analysts polled by Bloomberg News, for example, puts the S&P 500 at 1,234 by the end of 2010 -- a jump of 12% from last week's closing levels.

Backing up this thought is that even as the economy revs up, the Fed is likely to keep interest rates near historic lows as inflation remains in check. That would be a near-ideal environment in which to own stocks. "This is close to the 'Goldilocks' scenario for equities," JPMorgan strategist Thomas Lee wrote in a research report last week. Lee thinks the S&P 500 will rise to 1,300 next year.

Overlooked Warning Signs

However, despite Wall Street's growing bullishness, investors should be wary. If history is any guide, even the boosted outlook for GDP growth isn't enough to keep it on pace with the far more blistering outlook for corporate profit growth. While a sharp profit rebound compared to last year's carnage is possible, equity valuations are still getting heady.

And the last time professional money managers became this complacent -- at the start of 2007 just before the world tumbled into the financial crisis -- a lot of seemingly obvious warnings signs were being overlooked. "Institutional investors expect the global economy to land softly in 2007 and are positioning themselves for a year of growth that, like Goldilocks' porridge, is neither too hot nor too cold," a Merril Lynch survey of money managers in 2006 revealed.

Merrill Lynch, of course, was sold to Bank of America in a panic last year as the banking sector took on enormous losses. Merrill's massive leverage brought it to the brink of collapse -- a harbinger for a broader crisis that enveloped much of Corporate America. But at the time, investors were going into 2007 "confident in the strength of corporate-sector balance sheets and still believe that companies are underleveraged," the Merrill survey noted.

It's little wonder, then, that some of the shrewdest analysts look to overall sentiment as a contrary indicator to bet against. Given the growing bullish sentiment, investors would be wise to remain on the sidelines and look for more concrete evidence of a sharp economic turnaround rather than get swept away in another bout of euphoria.

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