The bears were left out in the cold this week as the market continued its uptrend. Inflation data came in milder than expected and earnings have been largely stronger than expected (which shouldn’t be too much of a surprise considering how much expectations were ratcheted lower ahead of the reporting season). The Dow Jones Industrial Average (DJIA) put in a solid performance, gaining 2.8 percent on the week, as the market was graced with strong earnings reports from Dow components Coca-Cola (KO: sentiment, chart, options) , Caterpillar (CAT: sentiment, chart, options) , Johnson & Johnson (JNJ: sentiment, chart, options) , and Honeywell International (HON: sentiment, chart, options) .
The S&P 500 Index (SPX 1,484.35) tacked on 2.2 percent last week and the broad-market index is now up 4.7 percent since the start of the year, as it has yet again begun to tag fresh multi-year highs.
But how have investors and Wall Street reacted? By piling on more pessimism. The New York Stock Exchange (NYSE) recently reported short-interest activity for April, revealing a jump to another record. In fact, from March 15 through April 13, the number of shares short on the NYSE increased by 4.6 percent. During that same time frame, the SPX gained nearly 4.4 percent.
A bit of history should give you healthy perspective on the current short interest situation. The NYSE short-interest ratio (total short interest divided by average daily trading volume) stood at 3.7 when the SPX peaked around 1,500 in early 2000. This is a noteworthy fact as the SPX closed Friday fewer than 16 points away from this round-number area. (As a side note, the equal weighted SPX crossed above 2,000 this week and is trading at an all-time high). With the NYSE short-interest ratio currently at 6.1, this is consistent with the level of shorting activity that took place during the mid-to-late 1990’s rally in the market and also the level of shorting activity that occurred as the market carved out its bear market lows in 2002-2003. Each of these periods were favorable for accumulating stocks.
In other words, despite the fact that the market may look “tired” or “overbought” from a technical perspective on a chart, the short-interest ratio continues to stand at levels consistent with bullish price action, which favors the bulls and suggests that any corrections will continue to be modest and short lived, unless and until we see a major capitulation in the short interest like that of early 2000.
As further evidence of skepticism that should ultimately provide fuel for a continued rally, let’s turn to the latest Commitment of Traders report, which is published weekly. Coming into last week, small traders of S&P futures netted the largest short position in the past five years. Furthermore, large speculators in E-mini S&P futures (which some suspect are hedge funds) also netted the largest short position in five years.
In both cases, these groups have been caught short preceding huge rallies in the market, and history seems to be again repeating itself. As we saw in May 2006, this level of pessimism from traders does not mean the market is “correction proof,” but keep in mind that the magnitude of the correction in 2006 was shallow with respect to the post-correction price action in 2006.
Meanwhile, the CBOE Market Volatility Index (VIX - 12.07) for SPX options continues to find support at its 160-day moving average, which resides at the 12 level. While moves down to VIX 12 might continue to cause some short-term hiccups for the market like moves down to the 10 area in prior months, it is also of interest that the SPX is up almost 50 points since the first test of this moving average on March 21.
So, while we might be transitioning into a higher volatility market environment, the early signs are the market can digest this, much like it did in the mid-1990s. I think transitioning into a higher VIX environment that is similar to mid-1990s would be a good thing, as higher lows on the VIX would make it much more difficult to identify the obvious “low VIX zone”, which inhibits market progress as everyone knows it’s a sure thing that you must buy put premium and pull back from buying stocks. This zone over the past year or two has been at or near the VIX 10 level.
Looking ahead to the rest of this week, a number of energy companies are scheduled to report earnings and it will be up to this group to maintain the positive momentum that has recently carried the broad market higher. Last week’s reports were dominated by financial companies, which saw a number of the big bank and brokerage firms reporting better-than-expected results. This positive news has helped to assuage some of the subprime fears that are lingering and give the sector a fresh boost.
For the sector to maintain its recent uptrend, it will be crucial for stocks in this group to continue trading above support after the economic data and the multiple earnings releases this week. Another positive report could help to boost this group once again. Elsewhere, traders will be closely watching the durable good orders report and the employment cost index for signs of slowing in the economy and growth in inflation.
April 16, 2007, will be remembered as one of the darkest days in the history of the Virginia Tech community and the world beyond.
