...and a Quant's Top Trio

04/28/2006 12:00 am EST

Focus:

Chris Johnson

Editor, The Winning Edge

For sophisticated traders and those who uses options, Chris Johnson, quantitative analyst with Schaeffer's Investment Research, should be on your must-attend list for Las Vegas. Here, he looks at the outlook for the general market and a trio of favorite sectors.

"The Dow industrials and the Nasdaq Composite recently each charged forward toward fresh multi-year highs as April options. The question now is whether some overhead resistance has dissipated due to April call options expiring, which could allow the market to advance further. Or will the market stall with a few sentiment indicators pointing to some investor optimism?

"Pessimism reflected in the CBOE equity put/call ratio continues to unwind as investors trade more calls relative to puts. This activity suggests that options traders are putting money to work on the long side of the market during earnings season. This pattern follows those of the last three earnings seasons investors busily traded puts in front of earnings and then rushed to buy calls when earnings results came in better than or in line with expectations. In each case, market prices appreciated, but were then followed by weakness after the brunt of results were posted.

"In other words, the market became overbought after earnings results, something to keep in mind as we move through the next two to three weeks. I also continue to watch asset flows within Rydex mutual funds become more pessimistic. My takeaway is that the market is engaged in a game of chicken, with fund flows and other sentiment gauges continuing to move in a pessimistic manner as the market marches toward new highs.

"April short interest numbers are beginning to hit the tape. The only change of note so far is a drop in the number of shorted shares on the Diamonds Trust the first such decrease since October 2005. Prior drops in short interest signaled the start of significant surges in DIA (and overall market) prices. But this strength comes with a cost; the fact that the shorts are now covering into the rally should lead to weaker technicals for stocks down the road. This is something to expect once earnings season has run its course.

"Bottom line? Expect prices to continue edging higher, as options activity, fund flows, and now short interest strengthen stocks. Earnings should be a fundamental driver for the unwinding of pessimism, while oil prices and inflation will continue to be the cloud looming over the Street. With technical support in place, good fundamentals (good earnings so far), and continued signs of pessimism in our sentiment indicators, this game of chicken should result in the bears blinking first and cash moving from the sidelines into stocks, rewarding the patient participants in the market.

"Meanwhile, several sectors are worthy of note. Short interest on the chemical group is climbing and is now higher than 49% of the readings over the past two years. Analyst rankings on the sector hold only 48% ‘buys’ or higher. Demand for chemical-related products remains robust (a result of the growing economy). The CBOE S&P Chemicals Index recently hit an annual high. Consider some exposure to this group while the negative sentiment toward the sector unwinds.

"Options activity on networking stocks remains near pessimistic extremes. The put/call open interest ratio for the AMEX Networking Index is currently within the top 2% of the past year's readings. Additionally, fewer than half of the analysts tracking the sector have offered up ‘buy’ rankings. Add in the fact that recent sector fund flows have been negative and you have the makings for some pessimistic sentiment. Despite its recent pullback, the continued pessimism noted above along with support along its 20-week moving average should bode well for this group.

"Pessimism on the biotech sector has hit a potential crescendo, as the sector's put/call open interest ratio is at an annual high. Analysts are similarly aligned, as only 40% of composite rankings on the sector are ‘buys.’ The sector has endured some selling that has resulted in a pullback of around 10% since February. But the AMEX Biotechnology Index appears to bouncing off its ascending ten-month moving average, a trendline it has not closed a month below in a year. Given the current negativity toward these stock, buyers should now enter the mix as the technical picture improves for this group."

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