Bearish Bets Show Stocks Can Move Higher

05/03/2007 12:00 am EST

Focus:

Mark Arbeter

Chief Technical Strategist, S&P Capital IQ

Mark Arbeter, Standard & Poor's chief technical strategist, says several technical indicators suggest the rally in US stocks will continue.

Despite the market's nice recovery and upside acceleration off last year's summer lows, some of the market sentiment data we monitor is 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. That 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.

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 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, right near the top of the range since 1994 and just below the all-time high of 7.5 in October 1996.

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 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 emini 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. 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.

The Standard & Poor's 500's old closing high of 1527.46 was set on March 24, 2000. As of the close on April 26, a new all-time high on the S&P 500 is about 2.7% away. We believe the index will likely establish a new closing high in either May or June.

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