Cheer at last from the markets.

Byline: ANDREW MILLER 

THE impressive rally in stock markets has continued largely unabated with equity investors treating all news as 'good' news.

At the time of writing, the S& P 500 has risen virtually uninterrupted for nine weeks, gaining over 30% since the lows in early March. We now feel that the rally is becoming increasingly defendable, as there has been a notable improvement in some of the 'leading indicators' of economic activity. Furthermore, news from the corporate sector has, on balance, been fairly positive in recent weeks, with few disappointing earnings reports coming from the US and Europe.

Overall, the shape of the rally (in terms of the sectors that have led it) and the breadth of the rally (the sheer number of stocks that have participated) do seem to indicate that the current market upturn could build into something more sustainable. We would caution, however, that in the near-term there is still a significant risk that the currently buoyant mood in markets could be upset by some worse-than-expected economic data - it is important not to forget amongst all the euphoria that the world is still in the midst of a deep recession.

It is also clear that equity valuations are no longer cheap, especially in developed markets.

Following the recent rally, the S& P 500 index is now trading on a 2009 price-to-earnings ratio of 22 times.

This alone is likely to limit the pace of gains over the coming months, unless there is a marked improvement in the global economy (rather than the gradual recovery we expect).

So, what are the portfolio implications of the recent market moves? Overall, we still recommend increasing risk, but following the rally we suggest this should be done in a cautious manner. In addition to equities, portfolio risk can be increased by adding corporate bonds to a balanced portfolio. Corporate bonds have seen their prices rally as risk appetite has recovered, but tend to be less volatile than equities.

For those who are only interested in equities, it should come as no surprise that the rally has been led by economically-sensitive 'cyclical' sectors. However, this has also caused a shift in valuations, which has led us to revise a few of our sector calls. The major change we are making this month is to downgrade consumer discretionary stocks as strong performance has left the sector's valuation fully anticipating the recovery. Meanwhile, the energy sector has struggled, but the relative improvement in the sector's valuation no longer justifies an underperform rating. We have, therefore, upgraded energy to Neutral. In any case, the recent rally in the oil price, if it holds, could well result in some earnings upgrades here in the coming months. Overall, however, we maintain our cyclical bias in equity sectors, as we expect further outperformance from cyclicals as the economic recovery gains traction.

Finally, in terms of trends between large company and small company stocks, it's worth noting that the latter have enjoyed huge outperformance since risk appetite returned to markets.

In the short term, they may struggle to make headway, but in the medium term we would expect good performance to continue.

All in all, there has been a lot for investors to digest over the past few months - and we would re-iterate that risk should only be increased in a cautious and selective manner, given that the economic downturn is not over.

Nonetheless, it is pleasing that the news from markets is no longer universally grim.

Andrew Miller is regional office head of Barclays WealthAll in all, there has been a lot for investors to digest over the past few months

CAPTION(S):

BETTER TIMES Indicators of economic activity are improving.