Stocks Headed Higher

Market sentiment suggests the market has further to run, maybe a lot further

In one of my favorite movies, Wall Street, Gordon Gekko, played by Michael Douglas, delivers his infamous "greed is good" diatribe. Greed may be good, but we think fear is better, at least for the stock market.

Despite the market's nice recovery and upside acceleration off last year's summer lows, some of the market sentiment data we monitor are actually showing an increase in fear, not optimism.

Major stock market tops are characterized by elation, ecstasy, and euphoria - not the fear of falling prices. We believe the combination of a fairly vibrant stock market and rising levels of fear is bullish for stocks, as sentiment gauges are best read from a contrarian perspective. We would use the bear's misguided feeling to our advantage.

One way to gauge market sentiment is to watch the short-interest ratio on the New York Stock Exchange. First, the short-interest ratio is the number of shares sold short divided by average daily volume. This is often called the "days-to-cover ratio" because it tells - given the stock's average trading volume - how many days it will take short sellers to cover their positions. Short sellers are, of course, betting on a price decline.

Since 1994, the NYSE short-interest ratio has oscillated between 3.7 and 7.5. The higher the ratio, the more investors are betting on a market decline. The lower the number, the more investors are looking for a rise in stock prices. The average ratio over this period has been 5.4. We view readings of 6 and above as bullish and readings of 4.6 and below as bearish. The current NYSE short-interest ratio is 7.4, or right near the top of the range since 1994 and just below the all-time high of 7.5 in October 1996.

For much of the late 1990s, when the stock market roared, the NYSE short-interest ratio remained in the relatively high range of 6 to 7.5. It wasn't until 1999 that the trend in this ratio started to fall, as the bears threw in the towel and covered their shorts. This led to even higher prices and the ultimate top in March, 2000. During much of the bear market from 2000 to 2002, the ratio lingered at moderately low levels, indicating a lack of fear, even though prices consistently fell. Wrong again!

In September and October 2002, right at the bottom of the bear market, the ratio reversed to the upside as the bulls threw in the towel. Over the past three or more years, whenever the ratio fell below 5, we got a pullback in the market. When the ratio jumped above 6, we had nice rallies.

With the ratio very high once again, and the market doing relatively well, the bears must have a case of severe indigestion and will, in all likelihood, be forced to cover their mistakes at even higher prices, adding more fuel to the fire.

One way to peer into the minds of the big futures traders is to analyze the Commitments of Traders Report. The Commodity Futures Trading Commission publishes this report every Friday in an attempt to provide investors with up-to-date information on futures market operations and to increase the transparency of these complex exchanges. The report provides information about changes in the futures positions of various types of investors.

There are three distinct players in the futures market: the commercial hedgers (smart money), large speculators (dumb money), and small speculators (dumber money). If we look at the current posture in the S&P 500 e-mini contract, commercial hedgers are net long the stock market, while large speculators are net short the market by a very large margin. The same situation can also be seen in the Russell 2000 e-mini contract. An e-mini contract is a portion of a standard futures contract. It trades in a highly liquid market and is more affordable for investors.

Small investors and large speculators are betting on lower stock prices. We will place a wager on the smart money; they are betting on further upside.

On Apr. 25, we predicted the Dow Jones industrial average would top 13,000 - a milestone - at the close, which it did. Although it got a lot of ink in the media, we don't find this threshold very meaningful. In our opinion, it does not represent important support or resistance, or a significant retracement level from prior declines. We think it's mainly a sentimental stepping-stone.

What we do see as significant is the S&P 500's old closing high of 1527.46, set on March 24, 2000. As of the close on Apr. 26, a new all-time high on the S&P 500 is about 2.2% away. Based on the S&P 500's recent angles of ascent, we believe the index will likely establish a new closing high in either May or June.

Does 1527 by June mean 1645 by year-end? We don't think it's likely. The S&P Investment Policy Committee continues to forecast a full-year advance of 6.5% for the S&P 500, based on our expectation of decelerating earnings growth. We see S&P 500 operating profits advancing 6.6% to 93.44 by year-end, down from the 15% growth rate seen in 2006 and 13% growth recorded in 2004.

S&P Equity Strategy recommends overweighting the S&P 500 consumer staples, financials, and health care sectors. We like the consumer staples sector because of the counter-cyclical nature of demand for many of the sector's products, coupled with increasing international sales exposure, which we believe will likely cushion vulnerability to slowing U.S. economic growth. We advise overweighting the financials sector in a contrarian call that reflects an improving technical outlook and our view that negative subprime-related news is now fully discounted in valuations. Finally, we are bullish on the health care sector. We believe investors will gravitate toward sectors, like this one, that have high profit growth predictability and historically defensive characteristics.

S&P chief investment strategist Sam Stovall contributed to this report

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