Friday's huge stock market rally is a great example of what can happen when the bar on expectations gets set very, very low. Heading into the European Summit mid-last week, expectations were for more of the same (read: nothing). Instead, the summit produced a few outcomes that were at least a bit more concrete than have been announced in the recent past.

An agreement was reached that relaxed restrictions on emergency loans for Spanish banks. In addition, the two bailout funds—the European Financial Stability Facility and its successor, the European Stability Mechanism—will now be permitted to recapitalize European banks directly upon a banking supervision committee being formed.

These are not silver bullets by any means, but they do show some willingness by Germany to compromise in order to save the euro (for now) and ease the crisis. Up next is this week's meeting of the European Central Bank, and hope is an interest-rate cut may be forthcoming. This could be the next hurdle for the market, and on this outcome the bar is not set as low as it had been for the EU Summit.

But for every hurdle cleared, there are many others that loom, including the US "fiscal cliff," European recessions, US slowdown, US elections and China's slowdown. With all of these significant threats, many are wondering not only how the market could stage such a rally as Friday's, but also why the market has remained so resilient.

The recent correction in US stocks was kept to single digits (barely) and Friday's 2.5% rally in the S&P 500® index brought the year-to-date gain to nearly 10%. Is the market, as a leading indicator, telling us that the "nattering nabobs of negativism" (credit to William Safire) have simply been too negative? Are the problems so known and obvious that they're already priced into markets, expectations and psychology? Or has the market been overly complacent and the worst is yet to come?

Caution still abounds (and is recommended)

We're probably not out of the woods yet and we remain cautiously positioned, as we have been for several months. And although Friday's action provides an example of the peril of taking a portfolio to pure defense, today's weaker-than-expected reading from the Institute for Supply Management on manufacturing has caused the market to erase some of those gains. This pattern of sharp rallies followed by equally sharp disappointments and pullbacks is probably with us at least in the near term.

In early April, I wrote a report highlighting elevated optimistic sentiment among investors as a reason for caution, given that sentiment (at extremes) acts in a contrarian fashion. As you can see in the chart below, thanks to the near-10% correction by the S&P 500 through early June, that optimism was wiped out and only now are we moving up from extreme pessimism territory. Frankly, I'd been hoping to see sentiment washed out even more.

Pessimistic Investors

Source: FactSet, Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2012 (c) Ned Davis Research, Inc. All rights reserved), as of June 26, 2012.

Do note that the best performance for the market historically has come when sentiment moves back into neutral territory from excessive pessimism. This is a path not yet confirmed by the latest move, but we could get there.

Investors have de-risked

Much of the popular sentiment data, including some of what's in the poll above, measures attitudes, not actions. When looking at the latter, we find that investors of all types have been de-risking for some time, which helps explain the ferocity of the rally last week. When a market shoots higher and investors are under-exposed, it can create a frenzy of buying.

ISI Group tracks the invested position of institutional stock managers as well as hedge funds. The former's exposure to stocks is presently at a low 66%, lower than at the market's bottom in early 2009. At a 44% net exposure to stocks, hedge funds are slightly less bearish relative to early 2009 (when they were at 42%), but well below the 50-55% that was pervasive in 2010 and early 2011.

The latest Commitment of Traders Report, a weekly indicator of open interest, shows the net S&P 500 position down to about -40,000, which is down from +40,000 in mid-2011 and equal to where it was at the pinnacle of the crisis in late 2008.

Finally, according to Wolfe Trahan, Wall Street strategists (present company excluded) are currently recommending investors keep 43% in stocks, having plunged from the mid-50s range at year-end 2011. Their recommendations are currently as bearish as they were at the market's low in early 2009.

As the Financial Times noted in an April article, "…institutional investors, from pension funds to mutual funds sold directly to the public, have slashed holdings in the past decade. Stocks have not been so far out of favour for half a century. Many declare the 'cult of the equity' dead." That's music to a contrarian's ears.

Oil doing Fed's prior job

Alongside the stock market's surge last Friday was a 7% jump in the Brent crude oil price (9.4% for West Texas Intermediate). As I've noted in many recent reports, the correlation between oil prices and the stock market has become quite tight relative to history. In fact, as you can see in the chart below, since the Federal Reserve took the fed funds rate to near-zero at the end of 2008, oil prices have taken over from rates as a mechanism for easing and tightening around the stock market's gyrations.

Oil Takes Over From Fed Funds

Source: FactSet, as of June 29, 2012. Dotted line represents date when Federal Reserve (on December 16, 2008) moved target rate to 0-0.25%.

US dominance

In addition to our more defensive posturing, we think several trends are likely to continue, and for tactically oriented investors, they can be considered as tweaks to portfolio composition. First would be our suggested bias toward US over international within the stock portion of portfolios. We're more favorably disposed to emerging-market than developed-non-US markets; and we continue to believe European stocks entail the most risk. In addition, we remain biased toward companies within the US market that have more domestically oriented sources of revenues—typically housed within the smaller-cap indices.

You can see in the table below the return/risk profile of small-cap stocks relative to emerging-market stocks. US stocks continue to be shunned broadly by investors relative to emerging markets, but when looking at the return/risk profiles, you can see that better returns have been achieved by US small-cap stocks, and we think that may continue in the near term.

Source: Strategas Research Partners LLC, as of June 29, 2012. Risk=standard deviation of monthly returns.

Macro and micro risks high heading into earnings season

We expect earnings season to bring some disappointments, especially among companies most exposed to Europe and a slowing China. Negative earnings estimate revisions jumped in June to 65% of the total, which is historically high. The only month recently when the percentage was even higher was last October. That did perfectly mark the bottom in the stock market before a huge 30% rally into early April of this year. I have concerns about this earnings season and believe estimates remain too high, but companies have certainly lowered the bar, which could mitigate the disappointment.

We also have election-year seasonals in the market's favor. In the 84-year history of the S&P 500, the stock market has been up 81% of the time in the second half of presidential election years, with a median maximum rally of 12% and a median maximum decline of 7%. The odds of encountering more than a 15% decline are only 14%.

We also have elevated risk of a recession, which will only grow as the fiscal cliff looms. But for now, the stock market, which is one of the better leading economic indicators in terms of "forecasting" recessions, is not pointing in that direction. However, caution remains warranted.