Scary Scenario for the Global Economy Still Looms

BOSTON (TheStreet) -- An improving U.S. economy and signs Europe averted a full-blown debt crisis have put investors in rally mode.

The benchmark S&P 500 of the biggest U.S. stocks on Wednesday rose above 1,300 for the first time since July. The index is up 4% this year after closing 2011 virtually unchanged even amid record volatility. The Morgan Stanley Cyclical Index, made up of companies whose fortunes are tied to the state of the economy, has soared 11% this year, led by Alcoa(AA) and Caterpillar(CAT).

S&P Capital IQ's chief strategist, Sam Stovall, is giving encouragement to investors beginning to flood back into equities. His economic observations include a frightening look back at how close the world came to an economic meltdown.

He recently wrote that there's cause for optimism about a resolution to the sovereign debt crisis of some sort in Europe, in lieu of a "triggering (of) a Lehman-like financial meltdown, but it can't be dismissed."

He's referring to the fourth quarter of 2008, when the S&P 500 tumbled 22.6% (the worst performance since the 23.2% drop during the fourth quarter of 1987) after the Sept. 15 bankruptcy filing of the Lehman Brothers investment bank.

And although the particulars have been in place for a falling-dominos-like event, Stovall's not predicting it.

"The overall picture in Europe has been improving, as encouraging demand for recent European sovereign debt auctions has buoyed investor optimism, while the low-cost (European Central Bank) bank loans have lessened the risk of a credit crunch," he writes.

But then adds: "The severity of the recession in Europe remains a wildcard. Our forecast is for a rough first half, followed by a slow uphill climb in the second half of this year."

But Stovall's still got some scary views on the world's fragile economy.

"Should there be another Lehman-like meltdown, and you wish to use history as a guide (though it's never gospel), I would suggest closing your eyes and preparing for a swift and severe sell-off in nearly all major asset classes, sectors and sub-industries, even with dividends added back. I would also venture to guess that you'll probably be glad you didn't sell your Treasuries."

Just be glad the Lehman debacle is behind us, but think about this: "At the risk of 'piling on,' " Stovall writes, "I remind you that all 10 sectors within the S&P 500 fell, even when including dividends."

The worst-performing industry wasn't financials, which fell 39.8%, but materials, which tumbled 42.4%. Technology stocks dropped 36.3%, industrials almost 34%, and consumer discretionary stocks 32%.

"Financials started tumbling earlier in the year and, in our opinion, many probably thought that the demise of Lehman would trigger a global depression, thus undermining the demand for materials by emerging market nations."

Given the sovereign debt crisis, many of the world's economic leaders have given a few sighs of relief in recent weeks, if they learned any lessons from the Lehman crisis less than four years ago.

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