Expect the choppiness to increase, though…

As you know, in predicting the current rally, I noted the extremely bearish investor sentiment, the extreme oversold condition of the major indexes beneath their long-term 200-day Moving Averages (MA), and early signs of improvement showing up in the housing industry (where I have said the first signs of economic recovery will begin).

I expected the market would realize the downside had been overdone at least temporarily, and would launch into a significant rally that could amount to as much as 50% for the S&P 500 (if it rises enough to retest the overhead resistance at its 200-day MA before the bear market resumes).

In just four weeks, the S&P 500 has gained 23%, the Nasdaq 26%, and the DJ Transportation Average 37%, already achieving the status of a significant rally. The market doesn’t often make that much in a year.

So, what are the odds of it continuing?

Let’s look at the conditions that launched the rally.

On investor sentiment, I consider the poll of its members by the American Association of Individual Investors (AAII) to have reached a level of excess bearishness (which prompts us to watch our market momentum-reversal indicators for a potential buy signal), once the bearish percentage reaches 55%. It reached a record 70% bearish, only 19% bullish a week prior to the beginning of the rally, and was still 54% bearish three days after the rally began.

In the opposite direction, history shows bullishness and confidence have reached an extreme that signals a top may be near, when the AAII poll reaches a level of 55% bullish.

As is normal, the percentage of bearish investors has been declining as the rally has continued. The latest AAII poll shows that bearishness has fallen to 37%, while bullishness has increased to 42.7%.

So, based on investor sentiment the rally probably has further to go if bullishness is going to again exceed 55% before the rally ends.

Next, let’s look at the oversold condition of the major market indexes beneath their 200-day moving averages. The oversold condition has obviously been partially alleviated by the significant rally. But if the major indexes are to completely alleviate the condition by rising enough to retest the overhead resistance at the moving averages, they have considerably further to go. For instance, the S&P 500’s 200-day MA, is at 1,006, which is roughly 21% above the S&P’s current level.

Next, let’s look at the improvements in economic reports.

In the latest available reports on the housing industry; new home sales rebounded 4.7% in February, the first gain in eight months; new home starts rose 22% in February; permits for future starts rose 11%; existing home sales rose 5.1% in February, the largest monthly rise since 2003.

Away from the housing industry; Durable Goods Orders rose 3.4% in February. Factory Orders rose 1.8%, the first increase in seven months; the ISM Mfg Index rose to 36.3 in March from 35.8 in February. A number under 50 indicates continuing contraction, but the higher number indicates the decline may be slowing. The ISM also reported its New Orders Index jumped to 41.2 in March from 33.1 in February (and its record low of 23.1 in December). That bodes well for future ISM Mfg reports, since obviously the orders have to come in before manufacturing activity can pick up.

It’s not all good news for sure. Auto sales continue to plunge. Mortgage foreclosures continue to rise. The employment picture continues to worsen, as indicated by Friday’s report that 663,000 more jobs were lost in March, and the unemployment rate rose to 8.5%, from 8.1% in February.

However, employment is a lagging indicator and not a place to look for early signs of the economy bottoming. Economic recovery is always well underway before businesses need to expand and hire more employees.

Financial institutions are still mostly basket cases, and will probably be the catalysts for the resumption of the bear market once this bear market rally runs its course. But even in the financial sector there are reasons for at least temporary encouragement.

Several major banks, including Citi, have indicated that after five quarters of losses they were profitable in the March quarter, at least on an operating basis (The operating profits will probably be wiped out by more write-offs of the toxic waste still on their books).

Some banks have said that to be on the safe side they took more TARP money than it turned out they needed, and would like to pay some of it back already. I think the Administration is wise to say “no” for now. There are probably more shoes to drop down the road for banks in the areas of commercial loans, credit card, and more mortgage defaults.

But updating the areas that prompted us to predict the rally in the first place does indicate the rally probably has further to go.

However, the market doesn’t move in a straight line in either rallies or corrections. And so far this rally has been pretty much in a straight line up. As can be seen in the charts on my daily blog that does have the market somewhat overbought short-term, and probably due for a brief pullback.

Meanwhile, we are entering the first-quarter earnings reporting period, which is not likely to be pretty. Like employment, earnings don’t stop falling and begin to pick up until well after the economy has bottomed and is growing again.

So while expecting the rally to continue, I expect it will become more choppy as it climbs a steeper wall of worry over earnings reports that will create period brief pullbacks.

The downside of choppiness and periodic pullbacks is that it will make it difficult for most investors to recognize when the rally does end (unless they pay attention to technical analysis and momentum-reversal indicators).