“Participants judged that the economy would continue to expand at a moderate pace in 2012 and 2013 before picking up in 2014 to a pace somewhat above what participants view as the longer-run rate of output growth.

Nearly all participants judged that their current level of uncertainty about GDP growth and unemployment was higher than was the norm during the previous 20 years. The main factors cited as underlying the elevated uncertainty about economic outcomes were the ongoing fiscal and financial situation in Europe, the outlook for fiscal policy in the United States, and a general slowdown in global economic growth, including the possibility of a significant slowdown in China.”

– Federal Reserve Monetary Policy Report to Congress (July 17, 2012)

According to the best economic minds on the Federal Reserve, no U.S recession is likely, but their uncertainty level is so high that they could easily be wrong. Come to think of it, when has the Federal Reserve ever forecast a recession until after the fact? I’m guessing never, so I take cold comfort from their forecast of continued moderate growth.

Of course, we can always count on the Economic Cycle Research Institute (ECRI) to bring some pessimism to the party. ECRI not only re-affirmed its recession call on July 10^th, but stated that the U.S. is already in recession. Virtually no one will realize the recession, however, until the U.S. Commerce Department’s Bureau of Economic Analysis (BEA) releases its final revisions of 2012 quarterly GDP numbers.

U.S. economic data has worsened considerably lately, including the first below-50 reading in the ISM manufacturing index (signaling contraction) since July 2009. The yield on 10-year U.S. Treasury notes sunk to yet another record low of 1.395 percent while 10-year German bunds dropped even lower to 1.23 percent, while the yield on Spanish 10-year debt rose to another Euro-era record high of 7.62 percent. These diverging government yields between strong and weak countries suggest massive financial panic about the possibilities of a Spanish default, as well as expectations that the U.S. economy will, in fact, fall into another recession.

Adding to the gloom are U.S. second-quarter corporate earnings, which a Standard & Poor’s analyst with the bearish surname “Short” predicts will drop year-over-year for the first time since 2009. Looking forward to Q3 and Q4, analysts are vigorously cutting earnings estimates to recessionary levels. Up to now, the “micro” earnings gains at the corporate level (thanks to cost cutting) have staved off the “macro” GDP slowing at the country level, but if micro is now following macro down . . . it’s a bit concerning, especially if you read John Hussman’s discussion of an “exhaustion syndrome.”

Why Are Stocks Still Strong?

Fortunately, investors aren’t buying GDP, they’re buying stocks and the stock market’s price action remains positive, continuing to defy the fundamental economic worries. How is this possible? There are two possible explanations: (1) stocks are anticipating economic recovery before it actually happens; or (2) stocks are anticipating a third-round of quantitative easing by the Federal Reserve, which acts like morphine for stocks even if it does nothing for the real economy.

I prefer the first explanation, but fear the latter. Academic research concludes that stocks lead bonds more often than bonds lead stocks — which is encouraging and suggests that TLT’s price rise will soon reverse  back down — and it’s also nice to see the housing market beginning to recover because housing is a large part of the overall economy and often is a leading indicator.  Economic slowing in China has often been considered the catalyst for a global recession, but China’s July’s manufacturing index came in at a five-month high, although it remains at a contractionary below-50 reading. If a recession is off the table, then it’s time to buy cyclical stocks because their valuations are currently cheaper compared to low-risk dividend stocks than they have been 96 percent of the time since the mid-1980s. Now that’s cheap!

But if stocks are only doing well in hopes of QE3, then we might be facing an unpleasant downward reaction in the stock market if QE3 doesn’t happen or only happens after a stock-market crisis occurs. As one analyst recently put it: “Investors want QE3 so badly, they refuse to accept the fact that there will be no QE3.” Oh boy. The odds of QE3 happening anytime soon don’t look good. In his recent congressional testimony, Fed Chairman Ben Bernanke gave no indication that QE3 was imminent, limiting his comments to the boilerplate language that “The Fed stands ready to do more asset purchases when needed.” In the recent monetary report to Congress, only two of 19 Fed officials (7 members of the Board of Governors and the 12 presidents of the Federal Reserve Banks) believed that an imminent injection of QE3 bond purchases was needed to keep the economy growing. Two people is not enough support to get QE3 off the table right now, but the Wall Street Journal is reporting that other Fed officials are growing frustrated with the weakening economy and may agree to act in September.

Technicals Still Look Good

From a technical stock chart perspective, the S&P 500 remains in an uptrend, with higher highs and higher lows since the June 4^th bottom. The 12-month moving average has turned back up and the S&P 500 remains above this critical support level of 1,300. No panic buttons should go off in anyone’s head while these positive technical conditions remain in place. On the negative side, China’s stock market broke below its October 2011 52-week low and is now in a serious downtrend, hitting the lowest level since March 2009 (3 ½ years ago). Let’s hope that the Chinese market is not a leading indicator!

Investor sentiment is extremely bearish which, from a contrarian standpoint, is quite bullish. According to the American Association of Individual Investors (AAII), investor bullish sentiment dropped 8 points to 22.2% in the week ending July 18^th, the largest one-week drop since April and the lowest bullish sentiment reading since August 2010. In fact, the 22.2 percent bullish reading is almost two standard deviations below the long-term average bullish reading of 38.9 percent.

According to Jason Goepfert of Sentimentrader.com, whenever the AAII bull ratio (bull percentage divided by sum of bullish and bearish percentages) is at 34 percent or below AND the S&P 500 is within 7 percent of recent highs, stocks have risen 88 percent of the time (22 out of 25 instances) over both the following three and six-month periods by 3.5 percent and 6.7 percent, respectively. The bull ratio is current right at 34 percent [22.1/(22.1+41.8)] and the S&P 500 is only 5.9 percent below its April 2^nd high of 1,422.38. Bingo! The last signal prior to the current one occurred on June 8, 2011 and it was one of the three losers, so nothing is guaranteed.

Furthermore, whenever the AAII bullish percentage has been below the average bullish reading for 15 consecutive weeks, stocks have been higher 12 months later 100% of the time by an average of 13.9 percent. This 15-week period of persistent pessimism occurred on July 12^th and is the first time this bullish contrarian signal has flashed since 1993!

The fact that Apple (Nasdaq: AAPL) – the largest market-cap stock in the universe — could miss earnings and yet stocks were able to shrug it off and rally huge today speaks volumes about the underlying strength in the market. When all the bears have left the building, only bulls are left.