Let this be a warning.  We are not out of the woods yet despite the market telling us otherwise.

The bounce off the March lows has been nothing short of spectacular.  Stocks, led by the technology sector have rallies over the last 2 plus months sending the major indexes to near break-even levels for the year. The bet, and it is nothing more than a bet, is that the credit crunch is over and that a recession, if any, will be short and sweet.

We are so good at sugar coating. 

Forget about higher oil prices. 

Forget about rising food prices. 

Forget about job losses.

Today’s wholesale price data with higher levels of inflation than expected should be a clear signal that the current market hypothesis may be a bit off base. Stocks dropped across the board on the heels of the announcement.  Stopping the slide thus far is that all important 1,400 level on the S&P 500.Will the market hold that level?

It will if the news stays positive, but that may be wishful thinking.

I’ve been amazed at the market’s resiliency in the face of seemingly negative news.  With that news becoming more and more suspect, it should not be a surprise to anyone to see the market drop from current levels.One reason for the market’s short term rally has been the quality of earnings during the first quarter.  Instead of contracting, corporate profits have actually been growing even in the face of a slowing economy. Of course, much of the good news has been coming from those that do business overseas.  The weakness of the dollar has been benefiting the exporters and that is a good thing. The bull case is further strengthened by the fact that losses are contained in the banking and mortgage financing sector.

But, what if all of this is a mirage?  What if the financial space sees more weakness, not the recovery that some now expect?

The answer to these questions may contradict the bull case.  As a result, stocks may suffer in the near term.Throwing caution to the wind in such a state may not be the wisest course of action.

Given the severity of the credit crisis and housing crash in the United States, does it really make much sense for the market to trade as it has?  That is to say, the market at its lows was in correction territory only. One would think a bear market, defined as a 20% decrease in market value, would be more justified.  If so, do we not have more to lose here? I would say the answer is yes, but I do not believe such a state would be the end of the world.  In fact, the economy is going through a period of digestion that is being assisted by Federal Reserve interest rate cuts.

The problem today is that those rate cuts are spurring inflation.  That means the chances for more rate cuts are quite low.  Instead, the economy must go through the necessary motions to find balance. That balance of growth and low inflation when it returns will be the basis for higher stock prices. Until that point, I would be prepared for a bumpy ride and a retest of the March lows.

Jamie Dlugosch
Executive Editor, InvestorPlace