"How many legs does a dog have if you call the tail a leg? Four! Calling a tail a leg doesn't make it a leg" Abraham Lincoln

Last's month's rally probably made the big picture quite a bit murkier in the minds of most investors...Despite (or because?) of the widespread predictions of impending "doom and gloom" markets shined with many beaten up "value plays" casually rebounding in high double digits and Dow up almost 10% off its March lows... But is this rally a true sign of things to come? Has anything changed fundamentally since the early March lows? Is it now safe to assume that US Economy is out of the woods? I don't think the answer is very clear at the moment, and thus anyone who answers this question with great confidence is likely to be simply wrong...

While on the surface last month's comeback could have hardly been any more convincing, it was not triggered, in my opinion, by solid and consistent economic data, but rather was a chain reaction in response to Fed's bailout of Bear Sterns. The implicit government's guarantee of virtually all and any counterparty risk has in effect eliminated a "bankruptcy threat" for any medium to large financial institution in the United States. This in turn led to drastically improved liquidity and lower spreads in the commercial mortgage backed securities market.

With fear dominating the headlines for the majority of the first quarter, volatility inflicted a severe pain to hundreds of large hedge funds out there, which in combination with Fed induced leverage crackdown on major investment banks, led to another simultaneous unwinding of leveraged short bets and triggered a massive short covering rally. Combine all of the above with seemingly never-ending gains in most commodities related stocks, add all the technically driven "signs" like higher lows, higher highs, "triple bottoms" etc and you've got yourself a recipe for a "healthy" rally

But let's be realistic. According to data from WSJ, of 678 companies that have reported so far (through Friday 18th) are down an astounding 22% year over year. It is true that Wall Street currently predicts a familiar "hockey stick" jump in earnings in the last two quarters of the year which, according to WSJ, is going to lead to almost a 15% full year gain in earnings for the S&P500? But I just simply don't buy into the notion that with economy at a virtual standstill or even in recession, total earnings could possibly grow in healthy double digits for the year. I think that earnings expectation for the second part of the year are still way too high, and thus markets will likely be disappointed come third quarter of the year...

But does it really mean you should sell your stocks today and run away? I don't think so. With so much cash still on the sidelines, and with momentum/technical investors finally jumping on the rally bandwagon, DOW could easily go up another 500 points... But in my opinion ,however, the total potential upside for the remainder of the year is limited to no more than 5% or 7% from today (roughly breakeven for most market indices). And if recession turns out to be more severe than what's currently expected (6-7 months of flat/negative growth), downside target would probably mean retesting January lows or roughly 7-8% from here.

It is true, that given the significant improvements in the values of commercial mortgage backed securities we might have already seen the ultimate lows in the financial sector. Tech sector is still growing in healthy double digits and industrials are benefiting from growing exports. But with commodity bubble looking increasingly unstable, and Fed's rate cutting cycle closing to an end, the current (3-6 months) risk/reward trade off is overall quite balanced in my opinion. So most of the potential upside from here will now likely come from picking better stocks and sectors, rather than from simple buy SPY and hold strategy...

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