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It is just like stock markets to ricochet from ecstasy to despair and back again. What is unsettling is that they are now doing so over the course of days, not months.

The market’s wild swing from euphoria on Monday to despair on Thursday to muted optimism on Friday demonstrates how unsure investors are about what lies ahead for the pandemic economy. Both bulls and bears can marshal good reasons for radically different points of view.

Bears can point to growing evidence the recovery will take longer than optimists had hoped. Both the U.S. Federal Reserve and the Organization for Economic Co-operation and Development (OECD) warned this week it would require at least a couple of years – maybe longer – to regain prepandemic levels of prosperity.

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a collapse in output followed

by a slow recovery

World GDP, index Q4 2019=100

106

104

November

2019

forecasts

102

100

Single-hit

scenario

98

96

94

92

Double-hit

scenario

90

88

Q3 2019

Q2 2020

Q4 2020

Q3 2021

JOHN SOPINSKI/THE GLOBE AND MAIL

SOURCE: oecd economic outlook

a collapse in output followed

by a slow recovery

World GDP, index Q4 2019=100

106

104

November 2019

forecasts

102

100

Single-hit

scenario

98

96

94

92

Double-hit

scenario

90

88

Q3 2019

Q2 2020

Q4 2020

Q3 2021

JOHN SOPINSKI/THE GLOBE AND MAIL

SOURCE: oecd economic outlook

a collapse in output followed by a slow recovery

World GDP, index Q4 2019=100

106

104

November 2019

forecasts

102

100

Single-hit

scenario

98

96

94

92

Double-hit

scenario

90

88

Q3 2019

Q2 2020

Q4 2020

Q3 2021

JOHN SOPINSKI/THE GLOBE AND MAIL, SOURCE: oecd economic outlook

The chief economist of the International Monetary Fund echoed those sentiments on Friday. Gita Gopinath said she expects to lower her growth projections when the IMF updates its forecasts later this month. “Significant scarring effects” on the global economy will take a long time to heal, she added.

Meanwhile, fears are growing that some attempts to reopen economies may be premature. Despite undeniable progress in containing COVID-19 in Canada, Europe and parts of the United States, the number of new infections per day worldwide is growing. Twenty-two U.S. states, notably California, Texas and Arizona, are reporting upticks in the numbers of new cases, according to The New York Times.

All of this buttresses the case for investors to be cautious.

Bulls, though, see an even stronger case for optimism. They point to central banks’ willingness to do just about anything to support asset prices. Don’t fight the Fed, traders like to say. Right now, that maxim suggests it is time to buy stocks.

The Fed signalled this week it will keep its key interest rate at near-zero levels through at least 2022. Ultralow rates mean ultralow bond yields. That leaves stocks as the only game in town for those who crave better-than-dismal returns.

The Fed’s moves to flood the U.S. economy with ready money add to the case for stocks. One key gauge of the broad money supply, known as M2, has surged skyward in recent weeks at the fastest pace on record. It would be no surprise if some of that money streams into the stock market.

And why not? “The valuations of most risky assets are currently not high in our view,” writes Oliver Jones, senior markets economist at Capital Economics. He argues that share prices are reasonable if corporate earnings recover next year as he expects.

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So what should investors do in this uncertain time?

You can start by putting your expectations in sensible shoes. A good starting point is the valuation model constructed by Aswath Damodaran, a professor at New York University. The model, explained in his Musings on Markets blog, incorporates several assumptions – how much corporate earnings are likely to fall this year, how quickly they will recover over the next five years, and so on.

It suggests fair value for the benchmark S&P 500 Index is now around 2,926. If that is accurate, stocks are probably overvalued after this week’s adventure, but only by 4 per cent or so.

This conclusion should soothe investors’ jangled nerves. But the model also demonstrates how sensitive stock prices are to relatively small changes in assumptions.

The profound uncertainty around many key assumptions means this week’s swings in market sentiment could be a foretaste of what the next few months will hold. Three questions, in particular, stand out.

One is about whether there will be a second wave of infections. The OECD Economic Outlook published this week charts two possible paths for the global economy – one with a single wave of COVID-19, another with a second outbreak later this year.

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In both cases, the global economy doesn’t recover its prepandemic level for at least two years. But in the double-hit scenario, the shortfall is far deeper and persists much longer.

Another key question has to do with politics. In February, prediction markets were sure Donald Trump would be re-elected as U.S. President. Now they have swung around to expecting a victory by presumptive Democratic nominee Joe Biden in November. They also see the Democrats possibly taking control of the U.S. Senate.

Such a shift could have big implications for share prices in the United States and Canada. A Biden presidency, supported by a Democratic Congress, could result in higher U.S. corporate taxes and shifts in key policies on trade and energy.

A final question has to do with public finances. In both Canada and the U.S., governments are spending lavishly to support locked-down economies, while central banks are expanding their balance sheets at an unprecedented pace.

For now, these policies are welcome. But it is not clear how markets, voters and governments will respond to greatly increased levels of public debt as well as low interest rates as far as the eye can see. Among other things, the combination will put pressure on retirement systems.

The combined uncertainties around viral outbreaks, politics and public policy add up to a potentially explosive mix. This is not a time for investors to be taking on more risk than they can comfortably bear.

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