Wall Street Grows Bearish

The downturn that skeptics have been bracing for may finally be here.

By + More
FE_DA_1130funds.chart.jpg
Slideshow: Is Your Portfolio Ready for a Double-Dip Recession?

Something hasn't felt quite right for the last few weeks, even though the stock market has been hitting new record highs and other economic indicators have been surprisingly upbeat.

[BROWSE: Political Cartoons on the Economy]

Investors and economists finally seem to be puzzling it out. While it seemed for a while that austerity measures in Washington—including the tax hikes and spending cuts that have gone into effect this year—might not slow the economy as much as once thought, it's now starting to look like the economy is simply undergoing a delayed reaction to those measures. "First-quarter growth was pretty decent but fraying seems to be appearing around the edges," economist Joel Naroff wrote in a recent report. "The impact of both the tax increases and spending cuts are cumulative, and it will take time to see how much pain they create."

One hint of trouble is in the labor market, where some economists are girding for a big pullback in hiring by late spring or early summer. Layoffs have ticked up recently, according to outplacement firm Challenger, Gray & Christmas. Part of that is coming from shrinking government – a known trend – but finance and retail firms also seem to be laying off more workers. That's worrisome, because those sectors are supposed to be stabilizing if not growing after sharp cutbacks during the recession.

U.S. employers have been adding nearly 200,000 jobs per month so far this year, but that could decelerate abruptly. Bank of America Merrill Lynch estimates that in April and May, job growth could slow to no more than 100,000 new jobs due to federal spending cuts. That would be a startling downturn likely to push the unemployment rate – perhaps the single most visible economic indicator – back up.

[READ: The New Underground Economy]

Incomes are also flat, which means a recent pickup in consumer spending could be fleeting. "The income of most U.S. households is barely keeping up with inflation," Russ Koesterich of investing firm BlackRock wrote in a recent blog post. That's better than falling incomes, of course, yet it also suggests that a recent spending spree has been largely funded by shoppers drawing down their savings, which can't go on indefinitely.

Economists have been puzzled by the strength of consumer spending, wondering if the cash economy has swelled to larger than its usual size or there's some other unusual explanation for a divergence between what people earn and what they spend. It could be, however, that consumers have been willing to extend themselves more than usual because they think the economy is poised for takeoff. If that doesn't happen, a pullback could follow.

A lot of investors have been expecting a modest stock market correction, as government austerity hits the real economy and corporate profits settle lower. Those prognosticators have been wrong up till now, with the stock market almost mocking austerity measures by hitting new record highs shortly after the spending cuts – which President Barack Obama warned would be highly damaging – went into effect.

[ALSO: The Stock Market Correction That Hasn't Happened]

But that doesn't mean a correction still won't happen, and if stocks get further and further ahead of the real economy, it will only mean a deeper dip, if it happens.

"The risk of a pullback in risk assets and the stock market is high," Merrill Lynch cautioned recently.

Still, most bears think a downturn and associated stock-market correction would last for only a couple of months, and generally set the stage for stronger growth and a more assertive bull market toward the end of 2013 and into 2014. The bulls won't hibernate for long.

Rick Newman's latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.