What to expect from the stock market in 2010.

The strong performance of the market since March ’09 has pushed many institutional investors to step back into stocks. Now that we are back to pre-Lehman market levels, investors seem divided about what the market next move will be.

I believe there are two possible outcomes for the year. As you will see even the brightest and smartest investors disagree:

It is the bullish theory: Axel Laroza, managing director at Lazard Freres Gestion explained it very in a recent article in Les Echos.

 Institutional investors are still way under-invested in equities and will have to keep buying stock in order to adjust that.

Companies have cut their investment and destocked so much in 2009 that they will have to adjust their inventories level, which will immediately boost economic growth and stock markets’ expectations at the same time.

Central banks are so concerned about deflation that they will keep interest rates low for quite a while.  Equities will remain the best asset class to invest in for the best part of 2010. Strong flow of money in the stock markets will push markets higher.

M&A will reappear as companies’ valuations are still low given the economic recovery around the world. 2010 will bring record deal on the table and will push markets higher too.

Here is the bearish theory: it is more or less the view of the most pessimist like Denis Kessler, Scor CEO.

Unemployment is at 10% in most of the G7 countries and even if Japan is much lower its unemployment level is at its highest in more than 50 years. These levels will worsen or remain stable for the best part of 2010. Consumption will not rebound in developed countries.

Countries’ debt is at very high levels. It has never happened in the past and it raises many concerns about the governments’ ability to decrease their debt levels. They will either have to hope for strong economic recovery the next two years or have to raise tax rates and push inflation way up. Either way inflation will be detrimental to sustainable stock recovery.

Countries’ debt levels are also a concern in case the global economic does not recover as quickly as expected. Governments, already too indebted,  will have no flexibility to come up with more facilitating monetary policies.

Expected growth of less than 2% in France for exemple, 1.4% for 2010, is not enough for companies to start hiring again. What if growth rate do not get to the 2% level for another few years?

Companies are experiencing the same inventories and debt reduction Japanese companies’ face in the 1990’s. If it is true it is just the beginning of a lost decade for the stock market.

Both scenarios are possible. I am more in favour of the second one. I don’t expect China to be the savior again in 2010. China is also facing the start of a bubble and they have to act fast before it is too late to prevent it. As a result China will have to implement tougher fiscal and monetary policy. The government will be more concerned about its domestic economy than helping the rest of the world. The absence of China on the international will be a prejudice for global economic recovery. If that happens, as I expect, the second scenario will take place and a second leg of the 2007 recession will emerge.

I am concern analysts tend to forget about macroeconomic issues. They seem to be certain we are experiencing a typical economic recovery. Historically when that has happened stock markets have enjoyed five year of strong growth. When I look at what is going on right now I am a little cautious about the wave of optimism.

I hope this will help you make up your own mind for 2010.