Stocks: The Bulls Come Out to Play

S&P thinks that the rally in bonds is over, and funds will move back to stocks as bullish sentiment increases

So far, so good, for the tenth month of 2007. We almost hate to say this, but we think the price action of the major indices has been picture perfect since the breakouts from many different looking intermediate-term reversal formations. We don't really know what so many are complaining about, but that actually gives us comfort from a contrarian viewpoint. But it also gives us heightened anxiety, which, of course, goes along with trying to predict the future.

So, what is this price action that looks so beautiful on the charts? First off, the breakout from the reversal pattern was a fairly large up day, something we believe is bullish when an index or stock emerges from a base or breakouts to a new high. Second, the market then dribbled lower very quietly, with small price ranges on the downside taking hold. This small pullback worked off a very short-term overbought condition, and set the market up for another breakout to the upside. In our view, this pattern of stair stepping higher is bullish and suggests to us that there will be additional gains down the road.

With the S&P 500 breaking to an all-time high on Oct. 5, we think there is a possibility that the index could pause in the near term, before moving further into unchartered territory. We would like to review some of the potential targets we talked about a few weeks ago.

Based on the width of the recently completed inverse, head & shoulders, we could see a measured move to the 1600 level. That is only about 3% above current prices, and with the very positive seasonals coming over the November to January timeframe, we think it is possible 1600 will be exceeded. An advance back to the top of the channel that the "500" has been in since last summer would target the 1650 area by the early to middle part of January. Another method of price projection uses the width of the correction and then multiplies this by 0.618 to come up with a target based on a Fibonacci extension up to the 1644 level.

Where is the money going to come from to propel the stock market higher over the next couple of months? First, we think there will be large asset allocation changes out of the bond market and into stocks. Technically, we think that the rally in bonds is over, and funds will move back to stocks. Second, the shifting market sentiment continues, with bullish sentiment rising and bearish sentiment falling. As this shift in market psychology evolves, we think it will support higher equity prices.

The 10-year Treasury note has had a very strong run since the middle of June, with the yield declining from 5.25% to a recent low of 4.3%. The bond market has reached very overbought levels from a weekly price basis, and at momentum levels that have been near intermediate-term peaks in bonds over the last couple of years. The 10-year note has also run into both chart and trendline resistance on the weekly chart in the 4.3% to 4.4% area, so we believe this is a logical spot to trace out an intermediate-term low for yields. In addition, a couple of weeks ago, the Consensus poll was showing an extreme reading of 78% bulls. This was the highest degree of bullish sentiment for bonds since the fall of 2006. That time period just happened to be right near an intermediate-term low for yields.

One never knows exactly when market sentiment has shifted too far to the bullish side, but we think there is more room for the continued migration from the bearish side. In some cases, there is a lot of room.

For instance, the American Association of Individual Investors (AAII) poll, while finally starting to show some faith in the market, is nowhere near bullish extremes seen in 1987 or early 2000. Oddly, the trend in this poll since the beginning of 2004 has been to the bearish side, despite a recent pickup in bullish sentiment. The latest readings show 52% of participant's bullish and 25% bearish. In early 2004, and right near an intermediate-term top, there was 70% bulls and only 10% bears. Back near the top of the bull market in 2000, the poll showed a peak of bullish sentiment at 75% and a low for bearish sentiment at 11%. At the top in 1987, the AAII poll was showing 66% bulls and a mere 6% bears.

Another sentiment indicator that we believe has a long way to go before forecasting a long-term top in the market is the NYSE Short Interest Ratio. Short interest spiked back up in September and the ratio is 8.1, just off the recent all-time high of 8.4 in July. During the latter part of the '90's, this ratio rose along with stock prices, a bullish sign. It wasn't until 1999 that the ratio started to fall, as the shorts capitulated and finally covered. While there is no guarantee that will happen again, there is certainly potential fuel from short covering to push the market higher.

Put/call (p/c) ratios continue to slide, as bearish bets get taken off and bullish bets get put on. These p/c ratios are well below the levels of a few months ago, but still have room on the downside before they reach levels that have been associated with market tops. Some sentiment gauges have moved far enough to the bullish side to warrant concern, such as the dramatic decrease in odd-lot short sales. Others, like the Investor's Intelligence poll of newsletter writers and the 3-week average of Nasdaq volume vs. NYSE volume have gotten a little frothy, but are not at extremes. Overall, however, we think there is still room for more bears to join the party.

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