It’s kind of funny how economic outlooks change from week to week, mostly based on the stock market’s performance.  All it takes is one bad week in the market and we start hearing the media calling for another recession.  When the market advances, media outlets say the recovery is intact.

I’ve viewed our economy in a relatively optimistic light even as I warned in late April that the stock market may be due for a correction.  Most readers know I believe the likelihood of a double-dip recession is overstated and policy mistakes are the biggest risk to a sustained economic recovery.  At the same time, it’s important to acknowledge that the economic recovery will not move in a straight-line.   This feeble, slow-growth recovery will be a bumpy ride and it won’t stop feeling like a recession until the labor market makes substantial improvement. 

For now, the markets have an appetite for risk.  Most people notice this in higher stock prices, but the fixed income markets tell the story as well.  High-yield bonds (also known as “junk” bonds) have a total return of 3% so far this month, and retail inflows into high-yield mutual funds have totaled $2 billion in the past two weeks!  Meanwhile, credit default swaps (insurance protection against a bond or credit instrument default) on the largest global banks have retreated to their lowest level in 12 weeks.

A combination of catalysts has played a role in lifting market sentiment in recent weeks.  The European stress tests’ methodology was laughable, but the tests worked in restoring faith in the Eurozone debt and money markets.  Mitigating headline risk has been important too, as the BP oil spill and the financial regulation bill moved off the front pages and got replaced by news that corporate earnings are meeting expectations. 

And we can’t ignore developments in Washington that include some Democrats calling to delay tax hikes in 2011 and the apparent death of cap and trade legislation.  More importantly, polls show that there is a good possibility for gridlock in Congress come November, which historically has been very good for the stock market.  Also in Washington, Ben Bernanke delivered a semiannual report to the Senate Banking Committee and said that monetary policy can be more aggressive if needed.  Bernanke also urged that Congress refrain from tightening fiscal policy.

How long will the market’s appetite for risk last?  Uneven economic growth will surely squash risk appetite again at some point.   I’d like to tell you exactly when that will occur, but I dropped my crystal ball in the rain last weekend.  If you follow the Economic Cycle Research Institute (ECRI) Weekly Leading Index, you may believe a downturn is just on the horizon.  Nevertheless, I am willing to bet that today represents an attractive entry point for a long-term investor.  Next week, I’ll show you why.

Peter Lazaroff, Investment Analyst

www.acrinv.com