Since its March 6 low the market has gained 39%.  It gained 5.9% in the week of May 8th alone, as participants breathed a collective sigh of relief that the government's stress tests for the nation's 19 largest financial institutions weren't as bad as feared.

The recent price action has been impressive, but everyone gets the fact now that the economic data, and the earnings results, have confirmed that the bottom for this economic downturn has been seen.  Knowing then that the market continues to squeeze more good news than seemingly possible out of the recovery trade makes us think it is ripe for a period of consolidation. 

The recovery argument is not without merit.  It should have fueled buying interest from the psychological, emotional, and numerical depths of the March 6 low.  The persistent nature of that trade, though, has the semblance of a conclusion that we are on the cusp of a return to trend GDP growth or better.

In light of all that has yet to be remedied, that's a dangerously Pollyannaish view that we think is consistent with a market that is at, or close to, a near-term top.

Not Quite Normal

The deep cyclical companies certainly aren't providing any reason to think trend GDP growth is right around the corner and neither are companies in the financial, technology and consumer discretionary sectors that have suggested they are seeing signs of stabilization.  That's good to hear, but just seeing things stabilize is a far cry still from normalcy.

Things can't be considered normal when companies continue to cost cut their way to positive earnings surprises. 

It isn't normal either that banks continue to set aside huge reserves for potential losses, that central banks around the globe continue to cut interest rates and embrace quantitative easing policies, that the yield on the 10-year Treasury note is 20 basis points higher from where it was when the Fed said it will purchase $300 billion of longer-dated securities, and that the unemployment rate is 8.9% and climbing.

Things are improved, which is plain to see in narrowing credit spreads and the economic data, but they are not normal.

Getting Carried Away

There will be a better sense of normalcy when good news is treated as good news and bad news is treated as bad news. 

Lately, there has been an increasing level of silliness when it comes to responding to better-than-feared news as if it were unequivocally good news.  To wit, the market looked thrilled after ADP estimated "only" 491,000 private sector jobs were lost in April (the govt. ended up saying it was -611,000) and after it was noted banks need to boost their capital buffer by $74 billion to be ready to deal with the potential of a worse-than-forecast economic environment.

Sure the news from ADP and the government stress test results was better than feared, but you'd be pulling Stretch Armstrong's leg if you called it truly good news.

In brief, we think the market is getting carried away now with the recovery trade. 

Writing on the Wall

We certainly don't begrudge the market for the move it has made.  In fact, we said we were looking for a meaningful rally and established 900 on the S&P 500 as an initial target.

The S&P has run through that target, but our reservation sets in with the premise that the market is now starting to price in the idea that this is a normal economic cycle and that trend GDP growth, or better, is right around the corner.

We find this hard to accept at this juncture knowing that banks, businesses, and consumers are all using less leverage than before.  This should continue to be the case for some time due to the increased government regulation for the banks and the increased self-regulation for businesses and consumers who have a newfound appreciation for saving money.

This shift was traceable in the latest Sr. Loan Officer Survey in which it was indicated demand for loans from both businesses and households continued to weaken for nearly all types of loans over the survey period, with the exception of prime mortgages.

So, the writing is on the wall so to speak that economic and credit conditions are improved, but that the trek to normal shouldn't be expected to be smooth. 

Not So Easy Anymore

The latter point aside, the market has a unique way of remaining in an overbought or oversold condition for a lot longer than many think is possible.  We have to respect this characteristic of the market, as well as the underlying angst among many money managers who still feel the need to chase this rally as they try to catch up to performance benchmarks.

That chasing, and the improved sentiment toward the economy and the impending fiscal stimulus impact, should keep the institutional bid in the market and prevent near-term corrections of serious magnitude.

The "easy money" from this rally has been made, however.  With the stress test results and the first quarter reporting period now out of the way, the bar of expectations for recovery is now considerably higher than it was in early March.

Participants may not sell in May and go away, yet the momentum-based trade is expected to slow as the material price appreciation since March invites more stringent fundamental analysis of return prospects from here.

A lot of potential improvement has been factored into stock prices, so much so that the market has all but dismissed the 2009 earnings outlook in favor of the 2010 outlook.  The risk there is that if data in the coming months, particularly spending data, disappoints, then the market will recognize that 2010 earnings estimates need to come down -- perhaps by a lot -- and will discount that fear in stock prices.

For now, the market will likely prove content to wait and see how the data comes in, comfortable with the thought that an inevitable restocking phase should make things look better rather than worse in the near term.

A Period of Differentiation Nears

According to Thomson Reuters, the consensus 2010 earnings estimate is $73.37, which is a 29% increase from the current consensus estimate of $56.94 for calendar year 2009. 

At its current level of 917.12, the S&P 500 trades at 12.5x estimated 2010 earnings. 

That isn't extremely rich, but with the continued weakness in the labor market and the understanding that bottom-up estimates are normally more optimistic than top-down forecasts, we're inclined to think the path of last resistance for the consensus estimate remains to the downside, which is to say the P/E multiple isn't the most credible source of valuation at this point.

Staying invested in core positions and continuing with systemic investments in retirement plans is the right thing to do, yet we believe it is advisable to trim positions that have enjoyed outsized gains during the spring rally and to add to positions in more defensive-oriented names that have trailed the move and will provide some dividend income during the waiting period. 

If circumstances and risk tolerance permit, an alternative approach is to purchase some insurance at least that will help protect gains in the event there is a more serious corrective move.

In the near term, we think it will be truer than ever that the market is defined as a stock picker's market since the likelihood is high that the market settles into a range-bound trade (825-1000 for S&P) as it allows the economic evidence to unfold.

We have seen the blanket sell off in stocks and now we have seen the blanket buy in.  Correlation factors with the market (think of the expression, "all boats rise with the tide") should decline and a differentiation trade between fundamentally strong and weak stocks should become more prominent in the summer months.