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The Stock Market Rally May Not Have Legs, But

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August 25, 2012 - The Rally May Not Have Legs, But - By Zacks Investment Research

By: Sheraz Mian

The market has wavered a bit in the last few trading sessions, but remains within striking distance of psychologically-important milestone levels. This begs the question: Can this rally be sustained going forward?

My answer is: No.

I doubt the rally's staying power and wouldn't be surprised if we give back some, if not all, of our recent gains.

My goal here is to explain this near-term view of the market, and along the way give you a few investment ideas to profitably navigate this environment.

Please note that this is only a very short-term outlook. I am just talking about the next 4 to 6 months. My outlook beyond that timeframe remains positive. A bearish short-term outlook does not mean a call to exit the market. I advocate staying fully invested and caution against market-timing temptations. But if you find my argument(s) agreeable enough, I do ask you to take a critical look at your portfolio to prepare for a period of above-average downside risk.

Markets Priced for Perfection

Here are some of the reasons that keep me from buying into the current complacent attitude towards the market:

• Be Skeptical of 'Decoupling' Theories: If the whole world is a mess, then it is bound to have a bearing on us as well. The funny thing is that nobody denies that the world economy is sharply slowing down. But they continue to believe that the U.S. economy will somehow stay immune from all these cross currents. Yes, it's been a long time since Europe was a global growth engine. But Europe is dragging down China and the other emerging markets (India/Brazil) and that is circling back to us. Be wary when you hear someone say that the U.S. economy had 'decoupled' from the rest of the world. It has not, and never will.

• The Fed Is Out of Bullets: Yes, they can do another round of bond purchases [QE3], lower the interest rate on bank reserves or maybe even extend their zero-interest rate commitment beyond the current deadline. All eyes are on Jackson Hole next week to see if Bernanke will tip his hand. But the goal of monetary easing is to improve liquidity and lower interest rates. The U.S. economy has none of those problems - we have plenty of liquidity and interest rates remain at historically low levels. The Fed can buy as many bonds as it wants, but more QEs are irrelevant to the real economy.

• Earnings No Longer a Market Prop: Earnings growth has slowed to a crawl. Corporate profits in the aggregate grow by two means - revenue growth and/or margin expansion. With the cyclical recovery almost three years old now, margins have already peaked and can at best stay stable. Revenue growth, on the other hand, is a function of nominal global GDP growth, and the global economy is sharply slowing down. We saw this play out in the second quarter reporting season when almost 60% of the S&P 500 companies missed revenue expectations. Even the not-so-bad earnings growth numbers were actually quite mediocre when you strip out the flaky numbers from the big banks. The bottom line is that earnings growth, which was a key source of support for this market since the start of the recovery in mid-2009, will no longer be there going forward.

I consciously stayed away from mentioning existential threats to the Euro-zone, our very own 'Fiscal Cliff' issues and the growth questions about China. The point is that the world economy faces a number of serious challenges, which are difficult to square with a stock market that is on the verge of multi-year highs.

How to Make Money in this Market

I am not making an Armageddon call or expecting a sharp fall off. All I am saying is that the market's recent gains and current levels don't make any sense to me. I expect the market to lose ground, and want you to be ready for that. Keep in mind that you can make money in any type of market, as long as you are properly ready for it.

You don't need to be a professional to make money in such a market. But make sure you understand that what worked in a bullish market will not be of much use in a bearish one. You can still find winners out there, but you need to do a bit more due diligence to identify them.

While such winners have many attributes, three really stand out - Earnings Growth, Quality and Valuation.

1) Earnings Growth: The most important attribute of a winning stock is its earnings growth profile. But just plain vanilla earnings growth is not enough to push the stock price higher. The stock's current price already captures the anticipated growth prospects. It is more about the potential for the stock to grow ABOVE current expectations that really make the stock soar. The Zacks Rank helps you capture this key growth potential attribute. At any given time, stocks with a Zacks #1 Rank offer the best earnings growth profiles leading to clear outperformance.

2) Quality: Here I am referring to the quality of the company's product/service, financial health and management. You want to invest in companies that enjoy competitive advantages in their markets, are in strong financial health and are led by a proven management team. These elements greatly increase the odds of success with your stock holding.

3) Valuation: If all the positives about a company are out there in the market, then you may have already missed the bus. How can you tell if that is the case? Looking at the company's valuation multiples, such as price-to-earnings (P/E) or price-to-book (P/B), and comparing those to its peers should give you a good idea of relative valuation. Buying a quality stock at a discount to its peers is one of your best bets to insuring a market-topping return.

To profitably navigate the current market and implement the above stock-selection framework, then please take advantage of the impressive array of resources on

Where to Start

A great place to find investment choices is the full list of timely Zacks #1 Rank Strong Buy stocks. You can also scan the list of #5 Rank Strong Sells to make sure none of those companies are in your portfolio. You can use these lists and a great deal more by trying Zacks Premium for 30 days free.

During that free trial, I invite you to check our long-term Zacks Recommendations, choose from more than 1,000 in-depth research reports, look up Zacks Industry Ranks for various stocks and see the Zacks Rank for mutual funds you own or are considering. You will also receive our latest Special Report, 7 Best Stocks for the Next 30 Days.

Best, Sheraz Mian

Sheraz is the Director of Research at Zacks Investment Research where he relies on access to valuable data to assess winning stocks and funds. Now, you can gain access to the same research he uses every day for free. Just try Zacks Premium for 30 days at no cost and no obligation.

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