Should You Be Buying Stocks Now?

Last Updated May 14, 2010 11:11 AM EDT

What's an investor to do? In the past three weeks, Greece melted down, a terrorist attacked Times Square, the Dow dropped 600 points in seven minutes and then spiked back up, BP befouled the Gulf of Mexico, and a volcano wrecked the airline industry's profit plans. If you're sensible you, um, buy stocks.

This isn't a forecast for tomorrow or next week. In the short run, anything can happen. For the mid-run, here's the case I've heard for U.S. equities:

We're in the early stages of a government-driven economic recovery. Manufacturing, production, jobs, consumer spending and capital spending on technology are all gaining ground. The rate of growth is only half of the average, post-recession pace. Even so, Allen Sinai, CEO and chief global economist for Decision Economics, describes the upturn as "entrenched, sustained, and sustainable."

Bearish sentiment jumped significantly last week, as measured by the American Association of Individual Investors' Sentiment Survey. To contrarians, that's a fine sign. In the typical business cycle, stocks rocket up from a recession bottom-a period when no one wants to buy. Next, they take a breather, which curbs any developing enthusiasm. Then they rise again, although at slower pace.

Inflation remains low. Euro woes are deflationary. In the U.S., spare capacity, high unemployment, a modest rate of consumer spending, and fierce competition make it hard for companies to put prices up. A vast amount of liquidity is sloshing around in the system, from government deficit spending both here and abroad. Where is it going? "Treasuries, equities, commodity prices, and gold," says Martin Barnes, managing editor of the Bank Credit Analyst in Montreal. "Everything is going up except the Consumer Price Index."

Super-low interest rates favor equities. Yield-seeking investors have been shifting into bond mutual funds, from money market funds that currently pay virtually zero. But all fixed-income investments are losers right now, says Steve Leuthold, chief investment officer of the Leuthold Group in Minneapolis. Interest rates will rise as the economy improves, so bond-fund prices are bound to fall. "Stocks will outperform bonds," he says. Many quality stocks pay higher dividends than the interest rates that comparable bonds provide.

On balance, investors in Euroland are shifting money into U.S. equities. Sinai also favors America over Europe. Painful spending cuts in the overindebted PIIGs (Portugal, Italy, Ireland, and Greece) plus the UK will slow the continent's growth. Odds are, the Euro will continue to slump, lowering the value of European shares in dollar terms (including the shares of international mutual funds). On the other side of the world, China is raising interest rates to rein in its pell-mell growth. Over the longer term, however, the so-called emerging countries-Brazil, Russia, China, India, South Korea-hold the strongest hand, Sinai says.

By contrast, Barnes makes a case for buying European stocks. Easy money will flood the Eurozone to help the weaker countries shore up their finances. Low interest rates, plus a sinking currency, will make the area's exports more competitive and encourage growth. "It's not a bearish story," Barnes says. Because of the plunge in Europe's equity markets, valuations there are better than those in the United States.

The size of the bailout package doesn't mean that the risks have gone away. "It's still crisis containment, not crisis resolution," says European bank-stock analyst Samy Muaddi of the mutual fund company, T. Rowe Price. But the banking system is stronger than it was prior to the 2008 Lehman Brothers crash. There should be time to see if Greece and the other weaker countries have the political will to endure prolonged austerity and make repairs.

Sinai remains pessimistic. Funds for a universal bailout still have to pass through Europe's national parliaments and "countries like Germany that run good businesses don't like funding countries that run bad businesses," he says. "The fabric of the Eurozone is at risk, and so is the Euro in its current form." In the end, Greece might have to renegotiate its debt or break from the Euro entirely. Other weak countries might come under market and political pressure to do the same.

Which brings me back to the issue of whether to buy stocks. Objectively, the market fright might present a buying opportunity. But "if you don't buy stocks, because you want to sleep at night, who is to say you're wrong?," Barnes asks. "There's a lot of downside risk."

More on MoneyWatch:
The Greek Debt Crisis
Everyone's Bullish on Europe So Maybe You Shouldn't Be
What's Behind Comeback in the Dollar and Where It May Go Next