Why Some Pros Still Believe a Big Stock Rally Is Coming

High unemployment? Check. A depressed housing market? Check. Strong potential for a global debt crisis? Check. Big stock market rally into the end of the year? Sure, why not?


Such is the case for stock market bulls, who believe that headwinds blowing from seemingly every direction will not get in the way of previously forecast stock gains that would take the Standard & Poor's 500 10 to 13 percent higherfrom current levels.

Their case is built on the notion that all of the prevailing obstacles in the economy will prove temporary and have caused stocks to become oversold. Once those issues fade, they say, investors will buy the current massive dip with both hands and push the market sharply higher.

"As the macroeconomic outlook stabilizes, equities should regain upside momentum," Barry Knapp, chief market strategist at Barclays Capital, wrote in his outlook for the second half of 2011. "We recommend buying domestic equities on weakness through the summer."

Knapp's forecast is fairly consistent with the consensus, which sees a possibly rocky summer followed by four factors likely to lift the market through the end of the year:

1. The Upside of Fear

The market is known for its contrarian nature—that is, when sentiment gets strongly positive a pullback is a good bet and when investors get overly panicky, it's usually a good time to buy devalued stocks.

Citigroup has a proprietary measure it uses called the Panic/Euphoria Model that shows investors much closer to the former than the latter, a sign it believes is positive for a market rally.

"There now is evident angst when talking stocks with investors domestically and abroad, while sentiment measures have plummeted as things clearly have deteriorated in the past two weeks," Citi's chief market strategist Tobias Levkovich said in an analysis. "Thus, it may be getting very close to sending a buy signal but we would become more aggressive if 'panic' was notable for a few weeks as seen last summer and in early 2009."

One key buy signal: A contributing factor to the selloff has been a composite cut of 0.6 percent to second-quarter earnings forecasts over the past quarter among S&P 500 companies. When stock selloffs stop on bad earnings news, Levkovich thinks that would foretell and bottom and thus provide a buying opportunity.

"In this context, late June preannouncements and the July earnings releases will provide the backdrop for sensing if the bad news gets priced in and thus may provide the reset trigger," Levkovich said.

2. Earnings Still Solid

Despite the recent trips to the confessional—the Wall Street term for when companies warn that earnings might be lower than expected—second-quarter profit reports should remain positive.

A good start to earnings, then, might get investors focused on corporate profits and away from all the economic gloom.

"Companies to date really have not seen dramatic slowdowns or anything worse than their expectations for the most part," said Gary Flam, portfolio manager at Bel Air Investment Advisors in Los Angeles. "To me this is Groundhog Day. It's very similar to what happened last summer. We'll have the same result as last year."

Indeed, the market spent much of the 2010 summer slump, in which stocks lost 17 percent, preoccupied with European debt concerns, natural disasters and the lack of a catalyst from Washington. While the problems seem substantially more serious this year, bulls are counting on the economy overcoming.

"As I look out over the horizon there are a lot of potential positive catalysts to get the economy and market going in the right direction," Flam said.

Overcoming the 'Soft Patch'

3. Going Hard Core on the Soft Patch

To believe in the economy, you have to subscribe to the notion that all the aforementioned factors weighing on the economy are mere temporary blips on the recovery's radar screen.

In sum, the Wall Street gambit is that Fed Chairman Ben Bernanke is correct when he labels as "transitory" the commodity price increases that have spurred a massive rise in food costsand until recently pushed prices at the pump to $4 a gallon.

Moreover, you have to believe the economy can withstand no recovery in the housing market, a political stalemate in Washington over the debt ceiling, and the constantly shifting winds in Europe as policy makers try to solve the spreading debt crisis.

Bernanke has repeatedly called the conditions a "soft patch" that will be resolved as the year progresses.

"We suspect the economy should recapture its upward mojo" in the second half, Levkovich said. "But, we cannot contend quite yet that the things we track are flashing the all-clear buy signal now even as equity markets have pulled back. Nevertheless, for those with six- and 12-month time horizons, the clouds may be breaking up already."

4. Low Gas Prices, Treasury Yields

Despite the recent drop in oil prices, inflation remains the great unknown for the economy.

The drop in gasoline prices has provided some hope that consumers won't be overwhelmed, and buyers of US Treasurys certainly don't seem afraid of inflation.

Bulls are hanging their hopes on the notion that the trend continues and the 3.6 percent growth in core inflation can be managed.

"While risks around Greece and the US debt ceiling have intensified, risks of an oil or interest rate shock have materially subsided," David Bianco, chief market strategist at Bank of America Merrill Lynch, wrote in a note to clients.

BofAML believes technology will offer the best option for investors in the coming days, while it also prefers dividend growth over dividend yield plays.

At Barclays, Knapp adds industrials and healthcare to the mix as he believes the market will post most of its gains in the fourth quarter after choppy second and third quarters.

"We maintain a bias toward cyclical sectors, but we are placing a heavier weight on valuation and cash flow," he said. "Core fundamentals, earnings and valuation remain constructive for US equities."