Why This Market Rally Lacks Staying Power

Last week provided our pundits with two important pieces of information. Unfortunately, neither of them gave any clear signs that the current rally will persist when trading opens Monday.

On Thursday, the Treasury Department released the results of its so-called stress tests that put 19 major financial institutions through a worst-case scenario to see how much more capital they may need to shore up their balance sheets if the economy fell deeper into despair. Treasury Secretary Timothy Geithner said earlier in the week none of the banks are in jeopardy of failing. However, the Treasury did say firms like Citigroup (C), Bank of America (BAC) and Wells Fargo (WFC) needed to raise a total $75 billion. Meanwhile, JPMorgan Chase (JPM), Goldman Sachs (GS), Bank of New York Mellon (BK), American Express (AXP), Capital One Financial (COF), U.S. Bancorp (USB), BB&T (BBT), State Street (STT) and MetLife (MET) were given healthy report cards.

Bank stocks moved up well ahead of the results, indications investors may finally be feeling comfortable enough about these institutions to start buying their shares again. Indeed, the shares of companies that were told to raise more capital rose faster than the ones given the all-clear.

But is this sector truly on the road to recovery? Not by a long shot, say our pundits. "Net-net, while the overall results make it appear that all is under control at regulatory mission control down in D.C., we believe that it is only another approximation game model," wrote David Hendler, an analyst with CreditSights, in a Friday commentary. "As the last several years of Wall Street model risk have shown, if underlying conditions change enough, output can change in a meaningful way, too. We believe that the market still wants to see hard-core credit improvement before it settles into a more comfortable rally zone."

The test results released Thursday were followed by unemployment figures the next morning. Friday's report from the U.S. Labor Department said nonfarm payrolls trimmed 539,000 jobs, considerably better than Street estimates of 610,000. While much of the gap can be explained by government hiring for the upcoming census, it's still a welcome sign that the labor market could be stabilizing.

Even so, our pundits are finding it difficult to hinge a rally on information that seems to be less-bad vs. truly positive.

Ed Yardeni, founder of Yardeni Research, wrote May 4 that while there's much to applaud, real recovery will include solid improvement on unemployment, consumer spending and stable home prices. That could take another six to nine months, though the news should improve during that time.

"In other words, a range-bound market seems more likely than either a bear or a bull market for a while,” he says. However, “I see more upside than downside down the road.”

That leaves investors in the difficult position of trying to participate in this rally while also watching out for any pullback. Thomas Lee, a U.S. strategist at JP Morgan, cautioned investors need to prepare for a correction in stocks. In a Thursday note, he said the sectors that are leading the current rally – financials, industrials and tech – should be watched closely. If they flag, a correction is on the way, even if it doesn’t match the apparent market bottom of March 9.

"We want to be 'slow buyers' of stocks, scaling in larger on the expected correction," he wrote.

Donald Ratajczak, an economist with Morgan Keegan, also sees another downturn coming. "While I believe that the bull market has begun, a strong rally requires corrections with rising lows," he wrote May 4. "The one-day corrections we have had since March 9 do not provide that type of developing support."