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Investors are leery, but stocks could keep climbing

U.S. equities slid across the finish line on Friday to cap the second straight week of gains. The Dow Jones industrials index rose 1.5 percent over the week to bring its month-to-date increase to 1.1 percent. For the year, however, the blue-chip benchmark is still down 4.5 percent.

The relief rally in February has been a welcome change from the harrowing sell-offs and volatility of January. But with so many negative catalysts still in play, many are wondering why stocks are moving higher and whether that trend can continue.

To be sure, investors have lots to be worried about.

While crude oil has recovered from its low near $26 a barrel, it has been unable to break above the $34 level over the last two months -- continuing the pressure on U.S. shale producers and increasing the pain for Americans employed in the energy industry.

Negative interest rates in Europe and Japan as well as concerns over energy sector defaults keep fueling banking sector worries. "Brexit" -- or a British exit from the European Union -- has been in the headlines. Chinese stocks suffered a big decline on Thursday. And U.S. corporate earnings growth has been negative for the past three quarters for the first time since the recession ended.

Yet positive are emerging as well. For one, bearishness and pessimism got a little out of hand. Last week, a Bank of America Merrill Lynch Global Fund Manager Survey showed cash levels at 5.6 percent of assets -- the highest since November 2001.

The Hedge Fund Trend Monitor from Goldman Sachs showed that hedge funds started the year with just a 45 percent long exposure -- down from a record high of 57 percent in early 2015 and the lowest level since the middle of 2012.

Hints of progress on two big issues -- a possible OPEC-Russia oil supply freeze deal and a possible delay to any further Federal Reserve rate hikes -- were enough to fuel a powerful short-covering rebound rally.

That is, the hedge funds and other professionals that had borrowed shares and sold them, betting on lower prices, have been scrambling to buy stocks to close their losing trades. That dynamic has been strong, helping beaten-down areas of the market such as mining and materials stocks lead the way higher out of the Feb. 11 low.


Just look at the chart above of the S&P Metals & Mining SPDR (XME), an exchange-traded fund that includes stocks like Newmont Mining (NEM) and Reliance Steel & Aluminum (RS). It has gained nearly 42 percent from its January low to return to levels not seen since early December. The S&P 500, on the other hand, is up just 7.7 percent over the same period and remains 7.3 percent below its early December high.

The rally looks like it has legs, with a group of OPEC countries and Russia set to meet in March (amid a deepening collapse in U.S. drilling rig activity), while the futures market doesn't expect the Fed to hike rates again until 2017. Heading into Friday's nonfarm payroll report, Deutsche Bank economists see a good chance of a 0.1 percent increase in the U.S. unemployment rate back to 5 percent.

The atmospherics of that change, reflecting a probable increase in the labor participation rate, will make it hard for the Fed to justify a rate hike at its March 16 policy meeting. And as we've learned repeatedly during the nearly seven-year-old bull market, nothing melts the hearts of fearful investors like a dovish Fed promising a take-it-slow approach to policy normalization.

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