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Q2 Kicks Off: Why the Stock Rally May Still Have Legs

The S&P 500's 12% gain to start the year gave the index its best first quarter since 1998, and if history is a guide, that may point to a continuing advance for the rest of the 2012 -- provided traders believe the Federal Reserve will keep the money spigot on and the economic data don't signal a collapse.

We know that past performance is certainly no promise of future results. After all, only days ago we noted that the S&P had closed 14 of the last 20 first quarters with a declining week, and the index showed us who's boss by climbing from the week prior. But the numbers do show that when the first quarter is strong, that often means an upbeat full year for stocks.

Giovanny Moreano, a quantitative analyst writing at CNBC, broke down the historical data. He determined that going back to the 1950s, the S&P has had 13 years when it rose more than 8% in the first quarter. Every time, the index ended the year in positive territory, though the pace of the rise didn't necessarily stay intact. Still, in each case except 1987, the year of the market crash, it was in the green for the last nine months of the year. (You can see his findings here.)

Before we get into what might be ahead, it's worth taking a quick look at what happened in the past three months. During the quarter, the S&P climbed above 1,400 for the first time since 2008. From its financial crisis low beneath 700 in March 2009, it's more than doubled. The best sectors so far this year have been the financials and information technology, each up more than 21%, and the top individual stocks have been Sears Holdings (SHLD), with a gain of 105.3%, and Bank of America (BAC), higher by 74.5%. In total, more than 80% of the S&P's stocks are up.

Did you miss it all? If so, you've got company. Many individual investors are still reluctant to fork over their cash for equities, having developed a serious aversion to the pain the market can inflict. Getting in now might take some nerve. Positive history aside, at least some degree of caution seems to be fairly common among market professionals, even if of late selling hasn't been.

Beginning to Look a Lot Like a Meltup

Morningstar only recently was keying on three factors that it felt would send stocks up this year, though not necessarily so rapidly. Those were: Demand for hard goods, healthy corporate balance sheets and better earnings, and "reasonable" profit multiples.

"We continue to believe the U.S. market will benefit from the first two, but after the stunning rally of the first quarter, valuations are not quite as attractive as they were," the firm said in a recent research report.

They're not alone. It's getting harder to track down wildly bullish forecasts for stocks. At the beginning of March, FactSet said the mean S&P price target from strategists was 1,410,
or about a point and a half from where the index ended up finishing the
quarter. What's easier to find is the view that equities have come a
long way in a short period of time, thanks especially to extremely easy
rate policies by central banks. If that continues, the big bid can, too,
but there's still plenty of reason to think the rally needs to at least
take a break.

"As money pours out of bonds and into stocks, if there is one thing that is clear it's that zero rates are forcing people back into the stock market," the traders who run MrTopStep.com, a futures and options education site, wrote last week.

The question then, as it often is, is when the upward momentum might slow. "While all the indices are going up, the nonstop rally in the Nasdaq futures is beginning to look like the meltup we saw during the 1999-2000 tech bubble," the site said. "Back then the 'day trading' craze was in full swing and most professional traders knew that would not end well, and it didn't."

Ben, the Trader's 'Friend'

Scott Bleier, the founder of Create Capital Advisors, is crystal clear on what he sees buoying stocks. "We are living again in a market that mirrors 2011 and 2010. We are living under a false construct," he said in a telephone interview. "You can talk all you want about money and about numbers, but there's only one thing that matters -- free money from the Fed or the ECB [European Central Bank]."

Bleier says he isn't short, that is, he's not betting against the market, but he's aware that the "false construct could fail at any time." The gifts from western central banks are keeping asset prices up, he says, though "if that ever stops, the market will be valued 20% lower."

So will it stop? Sure, one day. But the when part is key. As Bleier points out, Fed bankers are saying nothing is off the table, even if at some point, it simply has to end.

Ben Bernanke, the Fed chairman who, depending on your perspective, has either saved the economy or is leading it to ruin, has indeed said it wouldn't be wise to sound the all-clear. "We haven't quite yet got to the point where we can be completely confident that we're on a track to full recovery," he said during an interview with ABC.

Those comments and others have suggested the central bank might go for another round of "quantitative easing," by which it would buy bonds or implement another tactic to add money to the economy, a move inflation haters aren't anxious to see. Stocks, however, often respond well to signs that the Fed will keep the money flowing. Traders generally might dislike government intervention in the markets, but in the case of added liquidity, they'll take it.

Too Pricey ... or Not Too Pricey?

Economist and Yale professor Robert Shiller said on The Daily Ticker last week that he believes the market is a bit on the expensive side, though he would still lean toward buying stocks. At the same time, he doesn't think investors should go all in. John Campbell, a Harvard economist and a close colleague of Shiller's, addressed that theme with Mark Hulbert recently, saying stocks are "slightly expensive relative to their long-term average," though not yet at terrifying heights.

Using a valuation tool called the cyclically adjusted price-earnings ratio, or CAPE, Campbell gets a reading of 21.9. The long-term average of this particular stock price measure is below that, at 16.4, but it's been higher, and on notable occasions. Go back to 1996. Late that year, Shiller and Campbell had a talk with then-Fed Chairman Alan Greenspan about asset prices ahead of his famous "irrational exuberance" speech, and the CAPE was above 27. It had only been higher one time -- leading up to the market crash in 1929.

Long-time market watcher Charles Nenner appeared on Breakout to discuss what his charts are saying to him. Technicals aren't for every investor, but they absolutely play a major role in the daily movement of money in and out of assets. In Nenner's view, the rally has just about run its course. He's got a price target of 1,449 on the S&P, and believes "it's a little late to buy this thing." That's about 3% from Friday's 1,408 close.

An election is of course coming in November, and that may have something to say about the year's outcome as well. The S&P on average gains about 7.7% in presidential election years, according to research covered here. There's no doubt some U.S. data have been signaling a rebound and earnings have been positive, but other indicators have continued to point to a sluggish healing. Add in uncertainty about China's growth, stubbornly high unemployment, the sovereign debt situation in Europe, and you can see why it requires a little faith to believe that strength is more likely than weakness. But if it really is largely about the accommodating Fed, the rally might not be over yet. And again, history is on the market's side.

Barry Ritholz, CEO and director of equity research at Fusion IQ, a quantitative research firm, wrote about his perspective on the friendly Fed at his blog The Big Picture.

"There has been a solid bid under this market since October, goosed every time Ben Bernanke thinks about any form of liquidity," he wrote. "If he so much as eases himself into a hot bath, the market shoots higher."

Moreover, "The traders on the street -- essentially 2-year olds with fast computers that slosh around billions in assets -- know exactly how to throw a hissy fit. They are happy to whack the market 20% to get Ben's attention, and he seems happy to give them their binky to make them stop crying and go back to their cribs," Ritholz writes.

Welcome to a new trading quarter.