A post in March gave a list of reasons for expecting stock markets to rally. (A modified version of this piece appeared on the Telegraph website and elicited a torrent of hostile comment from enraged bears.) The MSCI World index (in dollars) has since risen by 10% and the FTSE 100 by 14% (to yesterday’s close). Is optimism still warranted?

One of the reasons for expecting a rally was that equities were then discounting an enormous amount of bad news. The first chart below updates an earlier comparison of the performance of world stocks in the current cycle with historical “soft” and “hard” landings – see here. At their March lows markets were fully priced for a hard landing scenario.

Following the rally, investors appear to be assigning roughly equal weight to the soft and hard landing scenarios. I still think a hard landing will be avoided, at least in 2008, but market levels are no longer hugely misaligned with economic fundamentals.

Another bullish argument was that plentiful global liquidity would be redeployed in equity markets as investors’ fears of financial meltdown abated. The second chart updates measures of G7 liquidity and risk aversion, last discussed here.

Liquidity remains ample although the indicator may be overstating the position because money supply figures have been distorted by the credit crisis. As expected, risk aversion has fallen and should continue to move lower barring further financial accidents. So the liquidity / risk backdrop still looks supportive.

The recent rally has been led by the energy and materials sectors but this pattern may be unsustainable, since further commodity price gains would threaten global growth prospects. A continuation of the uptrend in markets may therefore require a rotation of strength into other sectors, particularly beaten-up financials.

The third chart updates the comparison of the performance of US financial stocks during the current subprime crisis with the savings and loan crisis of the late 1980s, last discussed here. If the similarity persists – a big if – financials should soon embark on a strong recovery, which could sustain the uptrend in market indices.

Summing up, there are reasons to remain constructive on equities but some caution is warranted after the recent strong rally. Continuation of the uptrend is likely to require a stabilisation or modest setback in commodity prices along with a better performance of financial stocks.