After the major indexes slid about 4% in January and failed to make up all that lost ground in a volatile February, many investors are getting awfully nervous. They’re thinking that the surge on Wall Street at the end of 2009 was just a bear market rally and that it’s time to go on the defensive again.

It’s no wonder why. With a negative year-to-date return, it’s hard to believe that the market is on the way up. But this bearish outlook is flawed, and I believe wholeheartedly that the bull market is in fact charging on — and that it’s here to stay.

How can I make such a claim in the face of YTD declines for the S&P 500, Dow and Nasdaq? Simple: Investors must remember that this is a market of stocks — not just a stock market. The reality is that the bare indexes have masked a major turning point for the market, with a rotation from “junk stocks” into higher-quality stocks with dramatic upside potential.

In a nutshell, just because the stock market is down doesn’t mean that good stocks are down. It just means the cream has risen to the top while the froth has settled to the bottom of the glass.

Investors’ worries about the global economy and sovereign debt have punished stocks over the last few weeks, and not without cause. Reports persist that Moody’s and Standard & Poor’s could downgrade Greece’s debt to junk status, and the EU’s promises to backstop the Mediterranean nation against default have not eased concerns. On top of that, the latest job numbers released last week showed jobless claims reached their highest levels since November, renewing concerns about the weak state of the labor market. Coupled with a consumer confidence report that was the worst in 10 months, this news was not good for Wall Street.

However, there is no doubt that the economy is much more stable than at this time last year. The rate of job loss is at or near the bottom, and a recent survey of 56 economists in The Wall Street Journal predicts about 1.4 million new jobs will be created in 2010. So while things are still tough out there, they’re not tough for everyone.

So which companies are suffering? Well, it should come as no surprise to learn that the big losers are some high-profile stocks and that these corporations are holding back the major indexes. And frankly, these “junk stocks” deserve to take a tumble if the rally is going be based on real numbers and real economic opportunity instead of investment fads that treat Wall Street like a casino.

Look at American International Group (AIG), which rose 245% in the month of August alone on massive volume. That’s despite being technically bankrupt and bleeding red ink! Since Dec. 31, the stock has given up about 17%. No matter how you slice it, that’s a good thing since it proves the market is moving towards the proper valuation for this stock.

Fannie Mae (FNM) and Freddie Mac (FRE) saw similar gains last summer with +233% and +269% runs in August, respectively. Fannie is down 17% YTD, and Freddie over 20%. Bad for the aggressive traders who gambled on these federal-sponsored stocks, but very good for the market.

If you want to see how “junk stocks” like these have warped the market, check out my research across the entire market. I’ve placed stocks into five different slices based on their fundamentals, with the best stocks under my system in the first group (or quintile) and the fundamentally bankrupt stocks in the last. (These are the same slices I take of the market to rank stocks A through F in my Portfolio Grader stock ranking tool)

As you can see, at the dawn of the bull market back in March 2009 there was a dramatic rally among low-price and low-quality stocks as traders hoped for a big kill. That was despite the fact that these companies were projecting very bleak outlooks for the rest of the year.

I have to admit, riding this wave of optimism was awfully fun as stocks raced up from April to December. But now these inferior stocks are stagnating or falling. And with them, the optimism is drying up and holding back the broader market.

So what does this mean for investors like you and me? Well, first it means that we shouldn’t throw the baby out with the bath water. This kind of divergence is normal in the early stages of a bull market and not a reason to panic. Secondly, investors should see the recent contraction as an incredible opportunity to buy into high-quality stocks with great fundamentals.

After all, companies with growing sales and earnings deserve to succeed — and I promise you, they will! Historically, at the beginning of a bull market the higher-quality material takes off like a second-stage rocket, rising in a strong and steady arc.

While many market analysts fret over the fading fortunes of yesterday’s favorites, they’re missing the opportunity to rotate into these high-quality stocks. Don’t make the same mistake! Though it may not feel like it, the current turmoil in the market is a good thing for investors savvy enough to act.

Now that Wall Street is in a “show me” mindset, fundamentals are more important than ever. Check out my free fundamental stock-ranking tool Portfolio Grader for my analysis of about 5,000 of the most widely traded stocks on Wall Street. This will ensure you are buying the cream that will rise to the top in this challenging market.

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