In this environment, it's essential to separate economic recovery from market recovery. The stock market generally discounts economic expectations. So are stocks experiencing such a significant bounce because they overshot to the downside, or because of economic prospects? My guess is that it's a combination of the two.

Clearly, the Sept. 11 attacks created a climactic selloff that was based on emotion. Emotional moves in the market are typically reversed fairly quickly.

As a result, most sellers were taken out in the decline, which opened the door for some of the cash on the sidelines to enter the market. Emotional selling coupled with a "what could get worse?" sentiment created a perfect environment for a significant bounceback. So where does the impact of economic expectations fit in?

Getting Fundamental

If the rally was liquidity-driven and technical in nature, you'd normally conclude that a significant correction must be pending. This is where the fundamental expectations come in. From an economic standpoint, it seems pretty clear that the worst is behind us and that the economy is actually starting to move off the bottom.

The prospect of better economic demand should enable stocks to hold the bulk of their gains. But that doesn't mean the markets are going to surge ahead. The liquidity-driven rally now has to be justified by actual improvement in the economy. In other words, the market could go sideways until the fundamentals catch up to the higher valuations driven by the technical rally. If there were no fundamental improvement, then we'd surely have a correction.

Market-driven factors led to this rally, and current and future fundamental improvements should allow the gains to hold. That's the difference between now and the spring. The April and May rally was also technical, but it didn't have the fundamental backdrop needed to hold the gains.

The result should frustrate both the bears, who expect a retest of the September lows, and the bulls, who expect the improved fundamental prospects to lead to further significant near-term gains. After more than four years of high volatility, we're likely going to enter a period of lower volatility, in which we must again focus on managing our expectations.

Looking for Undervalued Opportunities

In doing so, I continue to believe stocks should be the best-performing asset class, but with much lower returns. Remember, to be bullish on stocks, you just have to believe they'll outperform fixed-income and money-market returns. I firmly believe that will happen over the next two years.

Assuming the market does become range-bound, being ahead of the rotation is essential to outperforming the markets. Once portfolio managers' performance anxiety is over, which should be in the next week, the larger funds will probably rotate to the most relatively undervalued areas.

The table below shows the key groups and the stocks in them that are undervalued relative to the market, based on where they've historically traded since 1987. To make it simple, if the

S&P 500

price-to-earnings ratio is 20, and a group or stock has a P/E of 10, then it would be trading at a 0.5, or 50% discount to the market. If its normal range were 0.5 to 1.5, then it would be considered undervalued, considering where it historically trades relative to the market.

The financial, technology and telecommunications (excluding the Baby Bells) sectors are overvalued relative to the market, while beverage, food, pharmaceutical and energy stocks are undervalued relative to the market.

Where's the Fizz?
The beverage group is trading at its low relative to the market

Source: Baseline

Why is relative valuation so important? Large-cap stocks have historically traded according to their P/E multiple vs. the S&P 500's P/E multiple -- not according to their P/E vs. their growth rate. A case in point is Wednesday's upside in

Procter & Gamble

(PG) - Get Report

, which was up 3 points on an analyst upgrade. The upgrade was driven by how cheap the stock is according to its valuation vs. the market.

Again, the case for relative valuation works as long as the P/E multiple of the market holds up, which I believe it will. The bottom line is that brushing the whole market with either a bullish or bearish stroke may not be relevant. Instead of trying to time the indices, look instead to buy those stocks that are undervalued relative to the market.

Anthony F. Dwyer is the chief market strategist of Kirlin Holding Corp. and managing director and chief market strategist of Kirlin Securities, its wholly owned broker-dealer subsidiary. Before joining Kirlin, he served as director of research and chief market strategist of Ladenburg Thalmann & Co. At time of publication, Dwyer had no positions in any of the securities mentioned in this column, although holdings can change at any time. He welcomes your feedback and invites you to send it to

Tony Dwyer.