Back in the second quarter our theme was “consolidation and continuation”, meaning we were looking for a market correction that would lead into a continuation of the bull market (See April 20, 2012 “Looking Ahead to Second Quarter”). Well, the correction we were looking for clearly unfolded, taking the S&P 500 down about 10% between April and June. More recently, the market has rallied 11% off the June bottom, and it is now beginning to feel like the continuation phase that we were expecting is taking hold. After an eleven percent run from June, we are forced to reassess expectations for the market going forward so we can position our client portfolios accordingly.
Judging the phases of a market rally (see chart below for the phases of a rally or decline) is imprecise and messy work, but helps give a framework for the potential risk/reward of investing at today’s levels. The current guestimate is that we may be passing through the disbelief phase of the rally that started in June. If the thesis is correct, then now would not be the time to sell this rally just because the market gained a quick 11% off the bottom. Instead it would suggest that we should use pullbacks to add to volatile holdings in areas that have built the most value over the corrective phase.
What I currently like most about this rally is that it is being accompanied by the combination of high skepticism, flush liquidity, green shoots and supportive election year seasonality. Tensions may not ease quickly, and the fiscal cliff and Europe may keep folks preoccupied for some time. But if we are correct, then the surprise in the second half may be how far this rally can run in the face of the large wall of worry that still surrounds us.