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How to React to the Recent Rally

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For over a year, advisors and investors have wondered, “How low can it go?” Now, the tide has turned.

Since the March lows, the S&P 500 (SPY) staged the biggest advanced recorded since the Great Depression. After a six-week winning streak, advisors and investors are itching to know if this rally has legs, and, more importantly, if the March lows represent the ultimate bottom of this bear market.

The recent earnings reports have been quite encouraging. Wells Fargo, Goldman Sachs, JP Morgan, Citigroup, GE and Google reported better-than-expected earnings. The Vanguard Financial ETF (VFH) now trades over 60 percent above its March lows.

Even long-time bears like Nouriel Roubini, one of the few economists who foretold the real estate/financial meltdown, and George Soros, the billionaire investor who came out of retirement to steer his Quantum fund to an 8 percent gain for 2008, belief that the worst is behind us.

What changed the minds of the long-time contrarians? Both expect the effects of the government stimulus to be reflected in an economic recovery starting 2010, an outlook that is highly debatable.

While this rally has more room to grow, the long-term prospects of the market continue to look grim. This long-term outlook is not based on “projected earnings” or “projected growth”, which have a tendency to change. Rather, this outlook is based on fundamental indicators with a long-term track record of accuracy.

Dividend yields, P/E ratios and investor sentiment – the stock market’s internal barometer – point towards lower lows. History shows that stocks have not hit rock bottom unless dividend yields, P/E ratios and investor sentiment reach extreme levels. (The March issue of the ETF Profit Strategy Newsletter includes a detailed analysis of the above indicators along with target levels for the ultimate market bottom.)