Stocks and other risk assets struggled last week, with the S&P 500 declining 1.11%.1 Equities finished lower on Friday, the final trading session of May. The decline trimmed Mays gains and sealed the second consecutive weekly decline for U.S. equities. The S&P increased 2.34% for the month and has gained 4.31% this quarter and 15.37% for the year.1

U.S. and global equities were under pressure last week, with all major U.S. indices lower for only the fourth time this year. With discussion of the Fed tapering its stimulus, market uncertainty gained momentum. The S&P 500 was down 1.0% for the week.1 We consider the market pullback technical in nature since the mention of a Fed quantitative easing exit likely created a natural point to take profits after the recent rally.

U.S. equities advanced again last week, with the S&P 500 increasing 2.1%. Global stocks are reaching new highs in this cycle and the U.S. market is at an all-time high. Bonds were hurt in the move, dragging credit down, while commodities fell slightly on weaker manufacturing data. The unrelenting equity rally and an environment without positive news about earnings and the economy is making many investors uncomfortable.

Last week U.S. equities advanced as the S&P 500 increased by 1.3%. We have been amazed bythe markets ability to continue to rally in an environment in which sales growth has been anemic and earnings gains have been largely based on companies abilities to manage margins and utilize financial engineering.

Last week U.S. equities delivered another gain as the S&P 500 increased by 2.0%.1 On Friday, the U.S. jobs report offered relief from fears of an accelerating weakness caused by prior softness during this time in each of the last three years. However, the full set of economic data for the week supports our view of a slower second quarter in a post-sequestration environment.

U.S. equities rebounded last week as the S&P 500 increased by nearly 1.8%,1 despite continued weak economic data. We believe recent data is not yet weak enough to change forecasts. The relative stability of data and forecasts - supported by stimulative monetary policies, an improving U.S. housing market and fading political polarization in the U.S. and Europe - sends a message of reasonably low volatility and manageable downside risks.

U.S. equities declined last week as the S&P 500 fell by more than 2.0%, which came on the heels of a new all-time high the prior week. Led by gold, commodities experienced volatility and declined over the past two weeks. Other detractors included disappointing first quarter Chinese economic numbers and somewhat softer U.S. releases.

We wrote Part I of this theme on February 11 during the first quarter rally, when the S&P 500 closed the week at 1518. This past week the S&P ended at 1589, after increasing 2.3%. Global stock prices continue to push to new highs and thus provide support for a pro-equity bias. One nuance is that the composition of the equity rally has been abnormally defensive.

The latest softness in economic indicators probably means that more consolidation in the equity markets is required before we can advance beyond the recent all-time highs. During March, nearly all of the activity for the S&P 500 was within 1% of 1550. Equities may move lower due to deteriorating technical conditions and the possibility of weak first quarter earnings reports.

This past month marked the fourth anniversary of the global equity market bottom on March 9, 2009. U.S. stocks have clawed back all of the losses from the Great Recession and are near historical highs. Most other major markets are still well below their 2007 peaks, but have rebounded sharply since last June and look increasingly resilient. However, there is tremendous anxiety about the economic outlook, and many investors fear equities and other risk assets are floating on a sea of liquidity rather than solid fundamentals. We are more constructive and maintain a pro-growth investment stance.

Equity averages sagged slightly last week. Strength later in the week made up for earlier weakness as the equity rally paused for the Cyprus crisis. We (and the consensus) perceive Cyprus as mainly a local problem and believe it supports our view to remain cautious with Eurozone weightings.

U.S. equities rose again last week as the S&P 500 increased 0.66%, with an overall gain for the year of 9.96%.1 The remarkable resilience of the U.S. economy against fiscal cliff headwinds has boosted equity investor sentiment. The U.S. macroeconomic outperformance has also helped U.S. equities outperform global counterparts. Investor preference toward the U.S. has largely been confirmed by rising flows into U.S. equities.

Investors are likely to remain volatile as the focus on the fiscal cliff will remain intense. Progress on the cliff needs to happen quickly if a compromise is to be reached. Given the sluggish nature of jobs growth, we are unlikely to see the Fed change its stance anytime soon.

The US elections are only two weeks away, and the recent polls show a very tight race. There are significant differences, both perceived and real, in the policies of the two candidates and the impact they might have on financial markets.

Although the economy does seem to have improved a bit in recent months compared to where it was in the second quarter, growth levels in both the United States and around the world will likely remain subpar at least through the middle of next year. The base case for the United States appears to be the economy continuing to grow at around 2% (perhaps a notch higher) over the course of 2013. This growth level would be contingent on avoiding the full force of the fiscal cliff and would be underpinned by a recovery in housing and a pickup in capital spending levels.

To at least some extent, the pause in the rally we have seen over the past couple of weeks can be attributed to some profit-taking on the heels of a significant multi-month uptrend (US stocks rose close to 6% in the third quarter). It is also likely, however, that investors are coming to grips with the fact that the world continues to face some serious risks and are recognizing that not all of the world's problems can be solved by central bank action.

Although global economic data has been relatively weak in recent years, risk asset prices have nonetheless advanced. We would attribute this trend to the fact that weak economic growth does not, by itself, limit the potential for risk assets. In our view, the liquidity-driven reflationary policies of the world's central banks have been a more important factor for asset prices than economic growth levels have been.

The headline news last week was the US Federal Reserve's announcement of a new round of quantitative easing in which the central bank plans to purchase $40 billion of mortgage-backed securities on a monthly basis (without a predetermined end date). The Fed also pushed back the timeframe on how long it will maintain its current zerointerest-rate policy, indicating that the current level of rates should be in effect through the middle of 2015.

Despite a relatively disappointing jobs market report for August, stocks rose last week as investors focused on the European Central Banks (ECB) announcement of its longawaited plan to buy bonds in the secondary market. The ECB program represents an important step in terms of lowering volatility and providing a cushion for Europes debttroubled countries to make some longer-term improvements in their fundamentals.

The Dow Jones Industrial Average fell 0.9% to 13,158, the S&P 500 Index slid 0.5% to 1,411 and the Nasdaq Composite lost 0.2% to close the week at 3,070. As August draws toward a close, US equities have hit four-year highs, corporate bond yields touched multi-year lows and many risk assets can look back on a pretty good summer. But despite plenty of investment and central bank activity, we continue to see a shortage of economic and financial market confidence.

One of the factors underlying the upturn in stock prices over the past couple of months has been a modestly improving trend in US economic data. Last week, retail sales advanced 0.8%, well ahead of expectations. This was the first increase in four months, which suggests that while households remain generally cautious, spending levels are beginning to tick higher.

Although investor attention seems focused on a number of well-known downside risks (including the European debt crisis, hesitant US economic growth and the pending US fiscal cliff), stocks have continued to climb higher and last week notched their fifth consecutive week of gains.

Although last week featured some lackluster economic and earnings news, investors continued to focus their attention on the growing possibility of additional monetary policy action, particularly from Europe. For the week, the Dow Jones Industrial Average climbed 2.0% to 13,075, the S&P 500 Index advanced 1.7% to 1,385 and the Nasdaq Composite rose 1.1% to 2,958.

Notwithstanding a pullback on Friday, stocks managed to post gains last week despite a generally negative tone to the economic data. In some ways, the recent trend of relatively weak data has actually been beneficial for stocks in that it has been boosting hopes for additional policy stimulus around the world. For the week, the Dow Jones Industrial Average climbed 0.4% to 12,822, the S&P 500 Index advanced 0.4% to 1,362 and the Nasdaq Composite climbed 0.6% to 2,925.

During a relatively modest week in terms of trading activity, stocks managed to stage a rally on Friday that helped erase the declines of the previous four days. The stock market gains over the past month can be largely attributed to the perception that policymakers in Europe have been making some progress combatting the ongoing debt crisis. There is a sense of uncertainty over the state of the US economy, and that uncertainty is making investors, companies and consumers wary about the future.

At the midway point of 2012, it seems an opportune time to review the predictions we made at the beginning of the year. Although much could change, at this point it appears that the majority of our predictions are on track.

Last week was a modestly negative one for stocks as investors continued to focus on a trend of weakening economic data. Additionally, many were disappointed by what was perceived to be a less-than-robust response from the Federal Reserve following its policy meeting last week.

The past two weeks have been better for stocks, with the major indices up in consecutive weeks for the first time in more than a month. Europe remains stuck in a cruel cycle of recession, a banking system in need of life support, frozen policymakers, too much debt and a downward confidence spiral. In the United States, economic growth slowed this spring (likely due to poor weather and the earlier spike in gasoline prices), but remains intact.

Following a significant slide the week before, stocks bounced back last week, primarily due to a growing sense that policymakers in Europe and the United States may be ready to engage in further easing measures. The increasing stress in Europe has put additional pressure on the European Central Bank (ECB) and on other policymakers to take stronger action, and, indeed, over the weekend European finance ministers announced a new plan to recapitalize the Spanish banking sector.

For some time, we have been suggesting that the US economy had been holding up relatively well compared to the rest of the world. While we are not changing that view, last weeks data (particularly Mays employment report) provided a negative jolt and pushed stock prices down sharply. Our summary view of the US economy is that while the United States appears to have entered another slowdown phase with the data growing more disappointing in recent weeks, the case for a renewed recession still looks flimsy.

Given our view that the European debt crisis should remain reasonably well contained and our belief that the US recovery remains on track, our outlook for risk assets continues to be a positive one. The combination of the rising equity risk premium, falling stock prices, improving corporate arnings and lower Treasury yields means that stocks have become quite cheap relative to bonds. Assuming that the world is not headed for a renewed deflationary spiral, there is little doubt in our view that stocks are poised to provide superior long-term returns over bonds given their current levels.

Although US economic data was generally good last week, stocks sank sharply as investor fears over Europe's debt problems intensified. Despite the mounting crisis in the eurozone, the US economic recovery continues to look stable. While it is true that US stocks have taken a turn for the worse over the last month, other markets (particularly European stocks) have been hurt even more. In our view, markets are awaiting some sort of positive jolt (perhaps in the form of a policy response in Europe or some stronger US economic data) to break out toward the upside.

It has been the case for some time, but recent events serve as a reminder that the primary risk to the global economy and markets is the ongoing debt crisis in Europe. Confidence over policymakers' ability to deal with the crisis took a hit recently given that the election results in Greece and France signal a shift away from governments' willingness to move forward with unpopular austerity measures. The resulting political uncertainty and investor confusion has put downward pressure on stocks and other risk assets. Unfortunately, the reality is there is no quick fix for Europe's problems.

There is a great deal of uncertainty that is acting as a headwind for the markets. In the United States, perhaps the main uncertainty is over the looming fiscal and tax issues that must be dealt with before the end of the year. Additionally, the still-developing European debt crisis has the potential to derail markets, as does the possibility for worse-than-expected economic growth. In any case, while we do expect to see markets continue to churn for the near term, we also believe that stocks will eventually be able to resume their climb.

At this point last year, two of the major downside risks were the possibility of the European debt crisis spiraling out of control and the inability of the United States to get its fiscal house in order. Today, while these remain two factors that have investors concerned and while there are some similarities between the situations one year ago and today, there are also some important differences. The US fiscal policy is murky. The tax and fiscal policies that are set to expire at the end of 2012 are clouded in uncertainty and it is impossible to view them outside the 2012 elections.

The economic backdrop continues to be mixed, but the overall trend continues to be one in which the US economy appears to be growing slowly. One interesting pattern that has emerged is that the US household sector has been picking up at the same time that the industrial side has been weakening. While an improving household sector is critical to ensuring long-term growth, there are some caveats to this trend. First, households have been dipping into their savings to boost spending, which is clearly not sustainable. Additionally, some of the growth may have been "borrowed" from summer quarter.

Given the relative differences between the economy in 2011 and what it looks like today, we believe the US economy will be more resilient than it was last year. We would also look to corporate earnings as a source of strength. Although we are forecasting that the pace of earnings growth will be slower this year than it has been in the recent past, so far the data has shown that corporate earnings have been doing just fine. Expectations for the first quarter have been set relatively low, but so far over 80% of the companies that have reported have surpassed expectations, which is a good sign.

Our overall view about the markets is that improvements in the global economic outlook, continued easy financial conditions and slowly improving investor risk appetites are all reasons that stock prices should continue to crawl higher. Markets have, however, paused somewhat in their rally over the last several weeks. This can be attributed to the fact that prices had risen so far so quickly and that markets were overdue for a period of consolidation or correction, but it is also important to emphasize that we will need to see further evidence of economic improvement for gains to continue.

So what are some of the improved economic conditions that have been pushing yields higher? We have devoted quite a bit of space in recent weeks to discussing the improvements in the labor market, and while jobs growth is certainly among the most important economic indicators, there are other factors that have been showing signs of improvement as well. Debt deleveraging remains a source of concern, but we have been seeing progress on that front. Individuals have been paying down their debt over the past few years and household debt levels have been falling noticeably.

While it is important to remain cognizant of the risks facing the markets, our overall view toward stocks remains constructive. Since the current rally began last autumn, we have seen some market pullbacks, but they have been brief and shallow, likely because many investors remain underweight equities and have been using pullbacks to buy on price dips. Now that bond prices are falling, we believe investors as a whole will finally begin to move out of Treasuries and into stocks. As such, as long as the macro fundamentals remain reasonably good, we believe equities should grind higher from here.

We believe the macro environment remains equity-friendly and we would argue that it still makes sense to retain overweight positions in stocks. The economic expansion should continue, inflation remains muted and central banks around the world are hyper-focused on maintaining easy monetary policy. Add to this backdrop the fact that stock valuations remain attractive, and the case for sticking with stocks gains strength.

Even with the S&P setting new post-crisis highs, we don't think stocks are ahead of themselves. While we may not be pricing in a recession like we did last October, markets are in the same place as last April but earnings are up nearly 15%. The October market bottom also seemed to have technical characteristics of an important low. While there remain plenty of problems, including rising oil prices and profit margins at very high levels, we recommend overweighting equities. For investors that are underweight equities, we recommend continuing to dollar-cost-average to increase exposure.

It was a relatively subdued week in terms of economic data, with the highlight perhaps being the weekly initial unemployment claims, which were unchanged (a stronger-than-expected result). This data helps confirm that improvements in the labor market have been gaining traction. This Friday we will see the February employment report and most economists are calling for a new jobs number of 200,000 or higher with a flat or perhaps slightly lower unemployment rate.

Looking ahead, we believe the backdrop for risk assets remains a solid one. The global economy is hardly experiencing boom conditions and remains subject to the hangover effects of the financial crisis, but improvements have been real and sustainable. Interest rates around the world are low. This backdrop, combined with at-least reasonable valuations, should help equities to continue to outperform. On a near-term basis, the improvements we have seen in recent months do appear to have been absorbed by the markets, which explains the recent nearly uninterrupted move higher in stock prices.

The risk on trade is the right one in the long term given that the worlds major economies are healing and that debt problems are slowly improving. These processes will not occur in a straight line and we will see setbacks along the way. The rise in risk asset prices, however, has been in a more-or-less straight line, with US stocks rising close to 25% over the past four months. As a result, at some point we will almost certainly see at least a pause in the upward move as markets experience some sort of consolidation or corrective action.

Notwithstanding the strong performance of the last month, we believe markets are still pricing in a more negative economic backdrop than what we are predicting. Investor confidence remains low and many are still sitting on large amounts of cash. It is important to remember that stock prices have not completely recovered from the significant drawdown that occurred in the summer of 2011, suggesting that markets have further room to run. We are not expecting to see uninterrupted smooth sailing from here, but we do believe that the trends for stocks are pointing in the right direction.

From a technical perspective, the market backdrop continues to be a strong one. All of the major indices are trading at above their 200-day moving averages and the advance/decline lines are trending quite strong. Additionally, mutual fund flows are starting to move in a positive direction for stocks with some evidence suggesting that investors are starting to get back into the markets (although the amount of cash on the sidelines remains high). Although economic and market data is looking better than it did months ago, it is important to remember that significant downside risks remain.

The recent bounce in stocks and in other risk assets can be attributed to a combination of some improved US economic data, a lack of significant new negatives in the euro debt crisis and further evidence of a soft economic landing in China. For the rally to continue, we believe at least two developments need to occur. The first is that we need to see policymakers in the euro area continue to stabilize conditions. The second is that we need to see global economic data continue to improve enough to support corporate earnings growth.

Skeptics would suggest that the solid start to 2012 is little more than a typical "January effect" in which stocks tend to rise at the beginning of the year, but we think there is more to it than that. In part, we believe the upward moves of the last two weeks can be attributed to the fact that many investors (including active fund managers) came into the year underexposed to risk assets following a disappointing 2011, and who are at this point beginning to put their cash to work.

The world continues to operate in a post-creditbust environment in which significant amounts of deleveraging still need to occur. The momentum in the United States is pointing in the right direction, but we do expect to see ongoing back-and-forth in the tone of economic data. Conditions will not continue to improve at the same pace we have seen over the last couple of months, nor will they deteriorate to the point that a double-dip recession becomes likely. Instead, we expect the economy to chart a middle course and grow somewhere between 2% and 2.5% for the year.