Last week, the U.S. stock market enjoyed its best weekly gain of the year, as well as its best one-day gain of the year on Wednesday June 6^th. While that is obviously good news, the rally occurred after a significant decline and could just be an oversold dead-cat bounce. Historically, some of the most impressive short-term rallies occur in the midst of bear markets. Furthermore, the impetus for the rally had nothing to do with improving economic data or strong corporate earnings, but rather the hope that things were so bad that the Federal Reserve and other central banks would engage in more monetary stimulus. When stocks go up based on hope rather than actual fundamentals, caution is warranted.

Now more than ever, the stock market and global economic outlook are uncertain – as uncertain as I have ever seen them. The bullish and bearish cases for the intermediate term are both persuasive, but only one can be right.

Economic negatives:

• Europe Debt Crisis.
• China cuts interest rates for first time since 2008, raising fears of economic hard landing. India’s economic growth is worst in nine years, suggesting widespread emerging-market slowdown.
• Economic Cycle Research Institute (ECRI) continues to forecast a U.S. recession and year-over-year growth in its Weekly Leading Index (WLI) has started to fall back into negative territory.   
• Former president Bill Clinton says that the U.S. is “already in recession” and Goldman Sachs CEO Lloyd Blankfein says that U.S. economy is in a “tough position” until the November presidential election and resolution of the “fiscal cliff” threat. However, Standard & Poor’s predicts that the U.S. Congress will show some rare bipartisanship and avoid the fiscal cliff. 
• Operation Twist is scheduled to end on June 30^th. Federal Reserve Chairman Ben Bernanke testified before Congress and gave no indication that further monetary easing was imminent despite the “rotten” May employment report. His complacency may be connected to the recent Beige Book report, which was curiously upbeat about the economy.
• Iran’s refusal to provide United Nations inspectors with access to the Parchin nuclear site leaves a Middle-East military conflict a distinct possibility.

Stock-market negatives:

• S&P 500 is on the verge of falling below its 12-month moving average, which historically has led to more downside. However, don’t panic – it hasn’t fallen below yet!
• Long-term bear market that began in 2000 still needs one more correction to complete a typical three-bottom formation. So far, only two bottoms have formed – in March 2003 and March 2009.

On the positive side, there is always the chance for more monetary stimulus, whether it be an extension of Operation Twist or more money printing (i.e., QE3). Some members of the Federal Reserve support additional easing, including Fed Vice Chairman Janet Yellen and Chicago Bank President Charles Evans. I wouldn’t want to be short when QE3 is announced!

The other positive is the historical performance of the stock market in presidential election years. According to Jeff Hirsch of the Stock Trader’s Almanac, since 1952 the S&P 500 has risen during the last seven months of presidential election years 87 percent of the time (13 out of 15). Furthermore, the Dow Jones Industrial Average has averaged a 9 percent gain in years where a sitting president is running for re-election (like this year). So, although Hirsch sees the stock market hitting a 10% to 15% correction bottom sometime during the July through October period, the market should rally significantly into year’s end. Personally, given the severe correction the market has already experienced, I believe the market low for the year is more likely to occur earlier in the July-October period rather than later.

Also encouraging is analysis from Ned Davis Research, which points out that a stock-market correction has historically occurred during the second quarter of most presidential election years. More importantly:

The correction has tended to be concentrated in the second quarter, setting the stage for a summer rally.

Also of interest is research from the Leuthold Group, which found that during the 1989-2012 period, “defensive” industry sectors (e.g., consumer staples, healthcare, and utilities) performed best between May and October, whereas “cyclical” sectors performed worst (e.g., consumer discretionary, industrials, and materials).