The rebound in the market has been strong the last few months with corporate earnings generally beating Wall Street’s expectations, suggesting a nascent economic recovery is already underway. While such rapid market gains are unlikely to continue and investors who sat on the sidelines missed a good portion of the rally, opportunities to “grind out” profits exist and RCM is shifting its portfolios accordingly.

“We were using market weakness to change the structure of the portfolios away from a more defensive stance towards more of a pro cyclical stance,” says Peter Anderson, co-CIO of RCM U.S. “We began shifting into more pro-cyclical areas back in November and certainly through March and April into areas such as technology, energy and consumer discretionary.”

The reason for the move to pro-cyclical stocks—stocks that generally move in the same direction as the overall economy—was due to a number of leading historical indicators of an economic recovery, including the shape of the yield curve, the amount of quantitative easing, inventory-to-sales ratio, peaking and initial unemployment claims.

“It’s been a tremendous recovery and very rapid recovery in terms of equity market performance,” says Scott Migliori, co-CIO of RCM U.S. He noted that the rally has been led by a number of cyclical areas, including energy, financial and consumer discretionary with RCM’s portfolios benefitting from exposure to those sectors.

Recently, RCM has taken profits in some of the cyclical areas that have had significant moves upwards, especially in the energy area, he says. “In general, most of our institutional portfolios are up year-to-date on an absolute basis.”

In the early stages of recovery, there has been a high correlation between cyclical stocks and the movement of the market. However, much of the shift toward pro-cyclical stocks is behind us, Migliori says. While RCM has benefitted from this trend, the landscape is changing and calls for a change in tactics.

As such, RCM expects it to be a stock-picker’s market going forward. “From here it gets a little bit more challenging. While we are still optimistic, I think it will be a slower march higher. Here I think it becomes much more stock-specific, which from our standpoint is not a bad thing, given our bottom-up track record, our strength in terms of Grassroots and our sector analysts,” Migliori says.

Still, clear favorable conditions have emerged. For one, retail investors have a lot of liquidity at their disposal. In addition, monetary policy has been very stimulative to the economy and, as a result, interest rates, have moved lower. Fiscal stimulus, which has come in the form of tax cuts, infrastructure spending, bailouts, and other government-sponsored relief efforts, has also been beneficial. In recent months, consumer confidence has improved and retail sales appear to be stabilizing and should move higher later this year, Anderson says.

Anderson also expects inventories will rebuild later in 2009. “We have pent up demand for both housing and autos.” For example, at the low point there were about 8.5 million automobiles sold in the U.S. whereas peak sales were close to 18 million cars. A rebound from such depressed levels is a reasonable expectation.

In terms of its macroeconomic outlook, RCM still expects a U-shaped recovery, with growth commencing in the third quarter of this year and slowly accelerating through 2010 and 2011. However, there remains the risk of an “L-shape” arc, where we hit bottom but fail to generate real economic growth. Equally as dangerous is what some people refer to as the square root, which is a sudden and very strong surge in growth followed by the economy going flat again.

In the near-term, Anderson believes that the U-shaped recovery will prevail with equity markets grinding to the upside. There will be pullbacks in the market, but we will not retest the lows seen earlier this year. From a secular standpoint, Anderson worries about U.S. debt accumulation. The government is running close to a $1.5 trillion budget deficit in the current fiscal year, close to a $1.25 trillion budget deficit in the following fiscal year and budget deficits averaging $900 billion to $1.1 trillion in the years following.

“That obviously carries with it significant risks longer term such as inflation, dollar depreciation, higher interest rates and higher taxes," he says. However, despite potential obstacles that could slow the pace of the recovery the more immediate future holds a number of attractive opportunities. While we have reduced financial leverage in the system, we are introducing steadily more operating leverage as we reduce inventories and we reduce employment, Anderson says. “That’s what has us excited about earnings prospects as we move into 2010 and a more vigorous economy.”