Three Reasons for Rally - 07/13/10

Retail investors are uninvolved and will likely redeploy cash into the equity market. Hedge funds have de-risked and will be forced to re-risk on any sustained advance. If bonds start to falter, a huge asset allocation trade into equities could ensue.

Since late June, I have argued that fears of a double-dip were misplaced and that P/E multiples had contracted to a point where I saw value for the first time since last fall.

I opined that the S&P 500 could move to around 1,150 in the last half of 2010, which would imply a near 15% rally from the lows a week ago.

I remain of this view, but I would caution that if the current soft patch is abbreviated, there are several conditions in place that could elevate stock prices beyond my expectations.

Specifically:

1. Retail investors are uninvolved. Inflows into domestic equity mutual funds have been nonexistent for an extended period of time. Market tops are usually associated with heavy retail inflows.

    

2. Hedge funds have de-risked. And they are only modestly exposed to stocks. Further signs of a sustained equity market advance will certainly lead to a re-risking as hedge-hoggers rush to rectify underperformance pressures.

    

3. If bonds start to falter, a huge asset allocation trade into equities could ensue.

In other words, there are few left to sell and a whole lot of potential buying interest. In fact, these three factors (above) could make my stock market forecast too conservative.