Image: Arrow Up © Image Source, Photolibrary

Right now the market reminds me of a set of Russian matryoshka dolls. You know, the ones that, traditionally, begin with a peasant woman, and then reveal smaller and smaller carved dolls nested inside one another, until the last doll is, traditionally, a baby.

This stock market, in my opinion, shows a short-term July rally inside a summer slump, inside an emerging markets rally, inside a liquidity-fueled boom, inside a liquidity-fueled bust.

That's why when anyone asks me "What do you think of the stock market?" my first question is "Over what period?"

Let me start with the innermost doll and work outward.

Short-term rally

Welcome to the (relatively short-lived) summer rally. From 1950 through 2010, according to the Stock Trader's Almanac, July has been the sixth-best month for stocks, as measured by the Standard & Poor's 500 Index ($INX). June, in contrast, has been the third-worst month.

This year the market tanked to a very oversold condition in June, setting up a July rally. Investors had been waiting -- as stocks got cheaper and cheaper -- for a break in the consistently negative news flow of May and June.

Image: Jim Jubak

Jim Jubak

Well, we're sure getting that break now. Greece and the European Union look like they'll succeed in their efforts to kick the Greek and euro debt crisis down the road. The European Central Bank has just about guaranteed it will raise interest rates on July 7 -- producing a euro rally against the dollar that will do wonders for commodity prices. (See my post on the Trichet rally). China's Premier Wen Jiabao has declared victory against inflation (another recent topic of mine).

It's important to remember that, in the short run, it doesn't matter if this news is actually real. All that counts is that investors convince themselves that it is.

And if you can judge from the technical charts -- and I think you can -- they believe. Yes, they do.

Technicals are bullish

In the past few days, U.S. stock indexes have rallied from support at their 200-day moving average, offering evidence that last week marked a short-term bottom, and that the indexes are ready to move back to resistance at their April highs. This is true for the Dow Jones Industrial Average ($INDU), the S&P 500 and the Nasdaq Composite Index ($COMPX).

Sectors, such as energy and materials, that had led the sell-off in May and June are bouncing off their 200-day moving averages, too, in anticipation of a weaker dollar.

Overseas markets show the same pattern. The iShares MSCI EAFE Index (EFA) has recovered to its 200-day moving average. (This index is weighted 66% to European stocks and 20% to Japanese stocks, so it should rally strongly with an appreciating euro.) The iShares MSCI Emerging Markets Index (EEM, news) has bounced so strongly off the 200-day moving average that it is now threatening to move above its 50-day moving average.

Expect short and sweet

Don't get too excited by this July rally. We had one last year too, and it pooped out in August. From a low of 1,023 on July 2, the S&P 500 climbed to a peak of 1,127 on Aug. 4. A 10% gain in a month sure ain't bad. But then the market decided to give most of that back with the S&P 500 falling to a low of 1,047 -- a drop of 7.1% from its Aug. 4 high.

That's typical for a summer rally -- short and sweet. If June is the third-worst month from 1950 to 2010, August isn't much better. It's the fourth-worst.

And I think there's good reason to believe that August could be disappointing again. Much of a July rally would be based on cheap valuations. Not just in the United States, where the S&P 500 was trading at less than 13 times projected 2011 earnings before this week, but also in emerging markets such as Brazil. At the June bottom, Brazil's Bovespa index traded at just 9.9 times projected 2011 earnings.

That makes the July rally kind of self-limiting, because every increase in stock prices means that stocks are just a little less cheap. And with the U.S. economy sputtering along in a weak recovery, it wouldn't take much in the way of a return of risk to end the summer rally. The most likely rally killer is the battle in Washington over raising the U.S. debt ceiling.