So has the economic recovery arrived or will the economy slip back into recession?

For many, this is the key question du jour and the answer will determine whether the recent stock market rally will prove to be just a bear market rally or the start of the next bull market.  Bull markets climb a wall of worry and amongst those currently worrying will be the camp who believe ”this cannot be a new bull market because the rally didn’t start from a single-digit p/e valuation level”.

By definition an economic recovery has to start with an initial single quarter of positive GDP growth (France & Germany reported positive GDP in Q2 and it is likely that the US & UK will report positive GDP in Q3).  Whether what follows are many more quarters of positive GDP growth nobody can know for sure at this stage.  This is why stockmarkets rally ahead of the first positive quarter as they are always trying to discount the future.  If this proves just to be a short-term bounce in GDP (driven by low inventories & pent-up demand) and the economy slips back into recession next year then stockmarkets will go back down again.  Whether they plumb the depths seen in the post-Lehman panic is most unlikely.  We have seen a V-shaped bottom in the markets since Lehman went bankrupt last September and these are most often associated with forced selling (c.f. March 2003 when the insurers were dumping equities).  Once all the forced selling is completed there are no sellers left and markets bounce back up again.  The stockmarket rout which followed the bankruptcy of Lehman caused quite possibly the biggest global margin call markets have ever seen.

As usual, there are many unknowns which include how the economy will repond when taxes are raised (to bring the budget deficits back under control), how the economy will respond when the BoE starts to raise interest rates, etc, etc.

The real answer is that no-one knows if this is a new bull market or just a bear market rally.  In the early stages of an economic recovery we just have to take things one quarter at a time.  However investors should take some profits once they feel the stockmarket has discounted a recovery (whether one subsequently appears or not).  Markets often change direction around Labor Day and with the FTSE nearing 5,000 at the end of a summer rally (having closed at 5,416 the day before Lehman went bankrupt), this feels like a good time for the sensible investor to adjust the shape of their portfolio by taking some profits and moving some chips off the table.  Any combination of top-slicing or switching out of high beta shares (miners, insurers and banks) into defensives (utilities, food retailers and telecoms) seems to be the best course of action at this stage.