Since the March 6 lows we have had an incredible 56% rally in the S&P 500 with only a brief 7% pullback, driven primarily (I believe) by 3 factors:

The perception that “things are not getting worse”
Stabilization of the financial system
Gigantic amounts of liquidity flooding the equity market. Money market yields of close to zero aren’t very attractive.

Based on consensus earnings estimates for the S&P 500, the market is trading at 19 tines 2009 estimates and a tad over 14 times 2010 estimates. The valuations are reasonable enough to support current market levels assuming the estimates are close to accurate. Experience tells me that earnings estimates are far too pessimistic at market bottoms and too optimistic at market tops, so only time will tell how good current estimates are. Over the next few weeks there will be a TON of earnings reports and these reports will greatly influence whether the market can sustain current valuations- or not. In the 2nd quarter, 75% of companies reported earnings that were better than expectations, but at the same time 70% missed their top line revenue estimates. Obviously, the strong earnings gains came from downsizing, rigorous cost controls, productivity enhancements, and while these measures are impressive and necessary, there is a limit as to how much a company can cut before impairing operations.

I am paying very close to the revenue number of the upcoming earnings reports. If revenues continue to be weak, even in the face of strong reported bottom line earnings due to cost controls, etc, this market rally may prove to be nothing more than a liquidity driven bear market rally. There still is a near record amount of cash sitting in money markets that can continue to fuel the markets surge in the near term, but eventually things have to “get better” as opposed to “not getting worse” in order to maintain current market levels. The upcoming earnings reports will give us a really good idea if things are , in fact, getting better. Buckle up and stay tuned.

I’d love to hear your opinion.