My Stock Winners

U.S. equities tried to rebound today, on the cusp of news that Goldman Sachs was injecting $2B of its own capital into one of its poor performing hedge funds (along with $1B in new investor money) with newly public Blackstone Group reporting that earnings jumped $500M in the latest quarter year over year. With less than an hour left in today’s session, the Dow 30 has slid from being up 80 to up 20 points, while the S+P500 was up about 17 is now up less than 4 points.

The NASDAQ was up early about 27 points and is now ahead less than 3, while the Russell 2000 opened and jumped ahead to 800.14, only to sell off, down about 8 points at press time. It looks like equities are staging a rally into the close from these levels. Here are the rest of the items that will drive trading on Wall Street this week.

On Tuesday, the trade deficit is expected to widen by $0.7B, to a negative $60.7B while producer prices are expected to drop by 0.1% due to the pull back in energy prices. Despite the news, crude oil was up $0.15 today to close at $71.62, despite being up as much as $1.42 to an intraday high of $72.19. Wal-Mart posts second quarter earnings, along with Home Depot, which is expected to focus attention on the renegotiated sale of their supply business to private equity buyers, as well as their announced $22.5B share buyback program.

Wednesday, look for consumer prices to rise just 0.11% in July due to the dip in energy prices according to Lehman Brothers. In June, prices rose 0.2% as gas prices fell slightly. Many market pros will likely use this as a “shot across the bow” towards Fed Chief Ben Bernanke as a catalyst for a cut in interest rates. We think Mr. Bernanke will likely utilize a new asset class similar to the one Mr. Greenspan frequently utilized. This time it will be known as the “Bernanke PUT.” In other words, don’t expect a rate cut.

Thursday brings the housing starts number, which is widely expected to fall 4% in July to an annualized rate of 1.41M units according to our good friends at Lehman Brothers. Any number north of that would likely diminish the “dead cat bounce” recently seen in that sector late last week. HP, Nordstrom, J.C. Penney, and Kohl’s all report earnings as well.

The week will end Friday with no big news or economic numbers slated for release. As we enter the “dog days” of summer, market participants will be hopeful that despite more hedge fund blowups, the bad news will be held to a minimum. While the OTCDigest.com would love to see the Fed cut interest rates, we can only imagine Mr. Bernanke will sit tight in his “long put position” in an effort to wring out the rest of the credit excesses in this debt driven market. Look for our Closing Market Commentary after the close on Friday!

Stocks opened modestly higher today with an absence of any earnings, merger, or economic events as only the Russell 2000 was down about 4 points at press time. Last week’s correction was the worst in several years and happened pretty quickly all things considered. Here are the events that will shape this week’s trading environment.

Thusday, look for strong job growth to lift personal income 0.5% in June although weaker spending will likely rise only about 0.1%. Consumer confidence is expected to rise to about 105.0 in July from a June reading of 103.9, while the Chicago purchasing managers index is expected to decline below the 60.2 mark recorded in June. General Motors reports earnings and expects to show a profit, while fashion maker Coach reports fourth quarter earnings with the consensus expecting $0.41 vs. $0.31 in the year ago frame.

Wednesday, motor vehicle sales are expected to show an annualized rate of 16.1 million vehicles in July, while Time Warner, Disney, and Kraft Foods are among the larger firms reporting earnings. Challenger, Gray, & Christmas report July job cut announcements while the ISM manufacturing index is seen edging down to about 55.5 in July. Thursday, look for the Bank of England to hold rates steady, while Dow component Eastman Kodak reports second quarter numbers.

Friday, expect non-farm payrolls to rise by 135,000 in July, with more than 100,000 jobs in education, leisure and hospitality, and business services offsetting losses from construction and manufacturing. Unemployment is expected to hold at 4.5% for the fourth straight month according to Lehman Brothers. The ISM non-manufacturing index is seen dropping to 57.2 in July, while Proctor & Gamble report fourth quarter results before the opening bell.

Stocks opened higher as M&A activity continued to be in focus as Hewlett Packard plans to acquire software maker Opsware (NASDAQ: OPSW) for $1.6 billion or $14.25 per share. On the earnings front, Dow component Merck (NYSE: MRK), along with Schering Plough (NYSE: SGP), and Halliburton (NYSE: HAL) beat earnings expectations and paced the market higher in Monday trading.

Today General Electric hosts a technology conference while the controlling family of the Dow Jones News Company contemplates a $5 billion buyout from Rupert Murdoch’s News Corp. A divided Board of Directors at Dow Jones has those following the deal wondering what will happen next. Meanwhile in Detroit, automakers begin negotiating with the United Auto Workers to formalize their next contract.

Tuesday look for St. Louis Fed President William Poole to discuss energy and his macroeconomic outlook, while Amazon.com reports earnings that are expected to rise 30% with earnings per share expected to more than triple to $0.16 up from a nickel. Wednesday brings the June existing home sales report, while May’s report showed sales fell to their worst level in four years with rising inventories. The Federal Reserve also releases its beige book survey of regional economic activity.

Thursday expect new home sales to drop by 1.6% to an annualized rate of 5.9 million that according to Lehman Brothers. Durable goods orders are expected to climb 2% in June, while Microsoft holds an analyst meeting and Ford Motor Company reports earnings. Friday, second quarter gross domestic product is reported with analysts expecting an annualized rate of just over 3% after a first quarter reading of just 0.7%.

The Dow got a boost from early strength in Verizon +2.6% and United Technologies up 2.28% and was up another 47.30 in late trading today. Despite blue chip strength the other averages were off, led lower by the Russell 2000 down about 1%. The Nasdaq lost about 0.36% and the S+P 500 just 0.19%. Here is your OTC Digest.com Weekly Preview.

In San Francisco today, the SEMICON West Trade show for semiconductor manufacturing opens. Financial markets in Japan and Chile were both closed today. Britain’s new envoy, Tony Blair is on his way to the Middle East for talks with the presidents of Israel and Palestine.

Tomorrow economists expect to see June industrial production up 0.5% after a May reading that was flat, while the Labor Department reports on June wholesale prices seen rising 0.1%. Tech heavy weight Intel reports earnings, along with other household names such as Merrill Lynch, Wells Fargo, Coke, and Johnson & Johnson.

Wednesday Fed Chief Ben Bernanke testifies on monetary policy in front of the House Financial Services Committee, where most analysts expect a repeat of the diligence against inflation theme. The Consumer Price Index (CPI) is expected to rise a moderate 0.1% in June, after May’s number ramped up 0.7%, the biggest jump in 20 months. The Commerce Department reports on June housing starts, with the annual pace expected to drop to 1.45 million, down 200,000 units from May.

Thursday look for Mr. Bernanke to continue his testimony this time before the Senate Banking Committee, while the leading indicator index is expected to fall 0.1% in June after picking up 0.3% in May. The Federal Reserve releases the minutes from their June meeting, while Motorola, Microsoft, and Google report earnings. Citigroup reports earnings Friday, while St. Louis Fed President William Poole speaks on the subprime mortgage situation.

Courtsey from OTC

The Dow 30 paced this week’s continued bull market in U.S. equities. The industrials gained 1.88% on the week (+257.28) to finish at a record high of 13,907.25. The S&P 500 gained 1.34% (+20.65) to finish near record territory at 1.552.50, as did the Russell 2000, adding less than 0.3% to end at 855.77.

Even as the above three indices achieved record highs, ominously absent from the party was the Nasdaq Composite. Perhaps even more amazingly, it will still require about a 90% gain from today’s close of 2,707.00 for the tech heavy OTC market to hit the record height of 5,132 established seven years ago in early 2000. The Nasdaq gained 1.38% (+36.98) this week.

Stocks shrugged off $74 per barrel crude oil price in Friday trading to power higher. Thursday’s better than expected same store sales numbers report was offset in early trading by this morning’s weak monthly retail sales report. A rumor that Warren Buffett might be interested in a stake in a homebuilder created a short squeeze in that beaten down sector. At the time of this release, no further news on the truth of such a development could be substantiated.

Well, this will be an interesting week as good earning has already been priced in. The market will need more push to keep going up and up.

While the Dow spread its wings to within striking distance of the 13,700 mark and the Nasdaq Composite hit its highest point since February 2001, it was the record achieved by the S&P 500 Index (SPX - 1,536.34) that was especially notable. The broad-market index finally notched a close above 1,527.46, its all-time closing high from March 24, 2000. The index ended the week nearly 10 points above this threshold, and is now staring down its all-time intraday peak of 1,553.11

This achievement in the SPX managed to grab a headline or two, but there certainly wasn’t a broad sense of euphoria accompanying the new high. The vague ennui of the investing public reminded me of the collective “yawn” I perceived several weeks ago after the Dow muscled above the 13,000 level. On April 30, I noted that: “Past breakouts had been met with a great deal of hoopla on Wall Street, but this one seemed to pass with more of a cringe and a groan, which is more encouraging than the rampaging enthusiasm that accompanied the technical breakouts we saw in the early months of 2000.”

Caution and skepticism prevail across Wall Street and Main Street, as investors have yet to fully buy into the market’s upward momentum. Institutions and hedge funds, which dominate trading in the U.S. market, continue to hedge their long positions by shorting other stocks, shorting index futures, and purchasing index put options, which are among the most-active options on a daily basis.

Mutual-fund players aren’t terribly sanguine either, preferring to avoid the playing field. In 2000, when the SPX was last in the 1,550 area, domestic stock funds enjoyed $259 billion in inflows. As of the end of April, domestic stock funds are on pace for only $63 billion in inflows this calendar year, as investment dollars continue to chase overseas markets. All of the broad indices are hitting new highs, yet the public is still not engaged. As contrarians, this is a welcome indication that plenty of money still lingers on the sidelines.

As an example of the pervasive shorting activity that continues as the market achieves new all-time highs, odd-lot short selling continues to build momentum. The smoothed 20-day moving average of odd-lot short positions has been slowly building up speed for the past 2 years and is now near a 7-year peak. Some are viewing the increased shorting activity as the work of hedge funds and thus not an indicator of pessimism surrounding stocks, with the implications being that short interest can no longer be used as a contrarian bull signal. My view is that regardless of the motivation for the huge short positions, they have to be unwound at some point in the future and thus represent future buying power.

Turning to the CBOE Market Volatility Index (VIX: sentiment, chart, options) , I have a few notable observations. The so-called “fear barometer” continues to respect the confines of the 12.50 and 14.25 levels as lower and upper bounds, respectively. The market will tend to struggle as this lower boundary is hit, while it tends to rebound strongly when the upper boundary is reached. Recently, these levels are regularly touched within a day or two of each other.

Meanwhile, the 30-day historical volatility reading on the SPX has been in a 9-10% range over past month, so VIX “premium” strikes me as being larger than normal. It could be that put sellers are no longer willing to accept the lower VIX levels of earlier this year, and put buyers jump in sooner on VIX pullbacks. Considering that this pattern is taking place amid a market making new highs, I view this activity as bullish, as put buyers are willing to pay higher premiums for portfolio protection, whereas the expectation would be that they are becoming more optimistic and thus unwilling to pay a premium for portfolio protection..

Additionally, even with the market at all-time highs, VIX futures remain flat, indicating an unusually high expectation for short-term volatility that has in the past always been associated with market weakness as opposed to the current upside momentum. Big volume on out-of-the-money VIX call options also continues to bear watching, as some investors are looking to cash in on a “VIX pop” that would result from a huge decline in the market and such expectations have a way of not being realized.

Overall, this landscape strikes me as quite bullish in its implications and provides a strong rebuttal to the “low VIX/complacency” argument that’s still out there.

This week, the economic calendar is fairly light; we’ll learn the results of April’s factory orders, wholesale inventories, and consumer credit and analyze the latest weekly crude data. Earnings season is certainly on the home stretch, with the retailing sector coming into focus. Among the names on deck for the earnings spotlight are Jos. A. Bank Clothiers (JOSB: sentiment, chart, options) , Guess (GES: sentiment, chart, options) , and Dollar General (DG: sentiment, chart, options) . We could well see another record or two, but don’t hold your breath for any high-profile celebrations.

Sluggishness in the semiconductor and Internet sectors, however, forced the Nasdaq Composite (COMP – 2,558.4) into a bit of underperformance; the tech-rich index edged 0.1% lower for the week. And the Russell 2000 Index (RUT – 823.66) of small-cap issues gave back 0.7% last week.

A relative-strength picture of the RUT versus the SPX is frankly not pretty. The market’s rally from its March bottom has been large-cap dominated. In fact, over the past couple of weeks, there have been definitive swings to negative breadth among the small caps, despite a relatively strong market. The blue-chip ride, on the other hand, has been much smoother. On a more positive note, this small-cap under performance has been incorporated into the “wall of worry,” as “weak breadth” is often cited by the bears as a reason to be cautious.

Part of the RUT’s recent struggle, as I pointed out last week, has been the heavy wall of overhead calls in the April and May series. I feel these out-of-the-money positions have capped rallies, but so far the June series is looking like a clearer path. How the June open-interest configuration develops over the course of the next week or so will be key to the small-caps’ short-term development, in my opinion.

As for the broader market, I told readers on Friday that my song remains largely the same. I’m still confident in some major upside from this point, at least over the intermediate term. Momentum remains solid, but we’ve seen muted fanfare despite positive earnings surprises, new record highs, buyback announcements, merger deals, and economic data that have been stronger than expected.

Skepticism (or, at the very least, a lack of enthusiasm) is still at a slow boil, as suggested by the latest from the world of the CBOE Market Volatility Index (VIX). The “fear barometer” continues to hang around the 13 level, several steps away from single-digit territory and more than 30% above the index’s mid-February low. I continue to be amazed (and encouraged) that the VIX is refusing to pull back amid our uptrending market.

The VIX’s inertia is a plus for the bulls for two major reasons. First, those who use the VIX to time the market won’t come out of the woodwork as sellers, because there hasn’t been a decline to warrant any selling action. Secondly, index put buyers are less apt to scoop up “cheap” portfolio insurance, which acts to cap the market as those selling the puts hedge via selling short futures. This routine will often cap market rallies as the VIX drifts to low relative levels. Note though that the VIX closed at 12.76 on Friday and is approaching the 12.50 level that has capped market rallies in recent weeks.

An article in this past week’s Wall Street Journal attempted to reason why the VIX is staying so stubbornly high. The speculative crowd may be to blame, the article reasoned, noting that “traders buying the November 18 [VIX] calls expect the VIX to rise by the fall … the traders sold put options on the VIX to effectively lower the cost of buying the calls…”

This is consistent with the mentality I perceive of those trading options on stocks and equity indices – they either sell covered calls or buy married puts. In other words, they purchase crash protection while limiting their upside. When it comes to options on volatility, however, the trend has been to buy VIX calls and sell VIX puts - with the same theme of limited upside potential for the market (since VIX put sellers are not expecting a huge decline in the VIX) and the urgent need for crash protection (which would cause a sharp spike in volatility, thus the potential for huge profits on VIX calls). I view the action on VIX options as a confirmation of the huge caution among stock investors amid the market’s rally. Such positioning continues to suggest that any pullbacks that might occur should be relatively muted, as those playing this market are hedged for a steep pullback and thus are less likely to panic sell.

On the equity-options front, while we are nowhere near the euphoric stage, which to me would be a sign to look toward the exits, we are seeing a bit more bullish positioning. Data from the ISEE reveal that those buying calls to open have begun to notably outweigh those buying puts. The trend is definitely moving toward the call direction, as evidenced by the data below and may be a precursor to some short-term market weakness:

With all of these factors in mind, this week could be a critical one for the SPX. At 1,522.75, it is five points away from its all-time closing high of 1,527.46, hit on March 24, 2000. This psychologically significant threshold could present a minor “speed bump” for the broader-market index, at least over the very short term. Structural support and a lack of euphoria should allow the index to muscle through this threshold soon, but it may face a bit of a road block in the very short term. This week, we have a number of earnings reports to keep market-watchers busy, particularly out of the retail sector. Durable goods orders for April will be revealed on Thursday, and we’ll get another look into the housing market Thursday as well, with the release of new-home sales.

A mixed slate of economic reports and earnings news failed to halt the broad-market rally last week, though stocks did pull back sharply on Thursday. At the close of the week, the Dow Jones Industrial Average (DJIA) finished with a gain of 0.46% while the S&P 500 Index (SPX) edged 0.02% higher. Furthermore, since the start of 2007, the Dow has racked up 6.9% in gains and the SPX has added 6.2%. And yet, pessimism reigns from a sentiment perspective despite this strong rally.

As we head into another options expiration, we have seen a steady rise in put positions on the various broad-market exchange-traded funds (ETF). During the same time frame, call open interest has increased by fewer than 370,000 contracts. As a result, the ETF’s Schaeffer’s put/call open interest ratio (SOIR) has risen to 2.21, its highest level since April option expiration.
Meanwhile, put open interest on the Standard & Poor’s Depositary Receipts remains at robust levels.
This building of put open interest is not only significant because its underscores the continued caution from institutional investors toward the market’s uptrend, as investors remain heavily hedged against a pullback, but also this wealth of put positions has accumulated as we approach expiration this week. In the past, we have seen an upside bias in expiration weeks due to the unwinding of heavy out-of-the-money puts that accelerates during that week. Since January 2006, the SPY finished only five expiration weeks in negative territory, while the average return during the week comes in at a gain of 0.55 percent.

One immediate obstacle that will need to be hurdled on the road to the all-time high I expect in the S&P 500 Index (SPX) this year is round-number resistance at the 1,500 level. The SPX has been dancing around 1,500 for about a week now, which is not surprising since this level had great significance as the SPX traced its major top in the first 9 months of 2000.

Checking in on the latest Commitment of Trader (CoT) report, it appears that large speculators in S&P e-minis haven’t quite finished covering their huge short position that we highlighted a few weeks ago in this space, as the net short position comes off its biggest level in five years and is now at levels consistent with the bottom of 2006 correction. Meanwhile, small traders of SPX futures are maintaining a short position that is hovering near 5-year highs.

This week has a number of key economic reports on tap, which could steal the spotlight. Inflation concerns will take center stage on Tuesday with the release of the Consumer Price Index (CPI). Last Friday saw a tame core Producer Price Index hit the Street, which helped to soothe fears. A benign CPI report could add some lift to the market. Meanwhile, Wednesday sees the release of industrial production and capacity utilization numbers, which will help the Street gauge the health of the economy. After the release of disappointing April retail sales and a larger-than-expected increase in the trade gap, expectations are relatively low on the Street regarding the economy. Any reports than come in better than the consensus estimate could result in a sharp rally in the market. Meanwhile, in the event of more disappointments on the economic front, declines should be modest, as heavy ETF put activity makes investors less apt to panic selling.

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.

Friday’s gift from the Labor Department of evidence that the economy still had some life it in has, thus far, been met with grumbling by Wall Street. Despite a closed market, the Labor Department announced that March nonfarm payrolls grew by an unexpected 180,000, crushing the consensus estimate for an increase of 168,000. What’s more, the unemployment rate dropped from 4.5 percent to 4.4 percent, matching October’s level, which was also the lowest level in six years. To add to the surprising robustness of the job market, February’s payrolls were revised higher by 16,000 and January’s payrolls were revised higher by 16,000.

In response to the strong jobs report, the dollar has rallied against the various foreign currencies, as fears have been at least temporarily allayed that the U.S. economy is still alive and kicking. On the other hand, bonds had sharply retreated.

The one repeated comment across the financial media in response to the payroll figure has been the fact that the Fed is now even less likely to cut interest rates now that there is fresh proof that the economy continues to chug along. But how likely was the Fed to cut rates if jobs had come up short? During his most recent speech on Capitol Hill, Fed Chief Ben Bernanke reiterated that the Fed’s main concern was inflation. Currently, inflation readings remain above the two-percent mark and outside the Fed’s comfort zone of one to two percent.

But my ultimate beef with the bearish take on the lowered likelihood of a rate cut is the fact that the bearish case since the 2/27 market plunge has been predicated on an economy that is about to implode due to various “excesses” that are about to be corrected. If instead the bearish case for the economy is exaggerated, then there is no need for a rate cut. My point is that the gloom that has accompanied the relatively minor February-March market pullback is now becoming impervious to how the facts are playing out, and this bodes favorably for a bullish resolution for the market.

Following the release of payroll figures, futures on the S&P 500 futures popped higher, indicating that stocks are primed for a potentially positive start to trading when the market opens again today. The broad market put in a solid performance last week, with both the S&P 500 Index (SPX) and the Russell 2000 Index (RUT) gaining approximately 1.6 percent. However, the small-cap index continues to be the leader on a year-to-date basis, with its return of roughly 3.3 percent, versus the SPX’s return of 1.8 percent and the Nasdaq Composite’s (COMP) gain of 2.3 percent. (For more of my thoughts on the outperformance of the small-cap sector, please read “;Schaeffer on Charts: Why Small Caps Make Sense”.)

But this doom and gloom from analysts isn’t limited to getting the hoped-for interest-rate cut from the Fed. Attention has now been turned to first-quarter earnings that will soon begin to wash over the Street, and expectations are extremely low. The latest from Thomson reveals that Wall Street analysts are looking for 3.3-percent growth in the first quarter and 6.3 percent for the full year. This consensus estimate is down from 3.8 percent and 6.7 percent just a week ago. In addition, an article in a well-known financial publication stated over the weekend that derivatives strategists are recommending that investors buy defensive puts to protect themselves from a moderate correction in stocks, as investors react negatively to the expected deceleration in corporate-earnings growth.

Evidence of this growing interest in put positions can be seen in the broad-market exchange-traded funds (ETF). The Standard & Poor’s Depositary Receipt’s (SPY: sentiment, chart, options) Schaeffer’s put/call open interest ratio (SOIR) has steadily climbed from a near-term low of 1.92 on March 23 to its current perch of 2.11. During this time, investors have added more than 490,000 put contracts and only 147,000 call positions among SPY options with fewer than three months until expiration. During that same time frame, the iShares Russell 2000 Index Fund (IWM: sentiment, chart, options) has seen its SOIR rise from 2.19 to 2.26. Put open interest for the ETF among near-term options has swelled by 407,000 contracts, while call open interest has jumped by fewer than 135,000 contracts.

This growing pessimism among investors is underscored by the fact that they are jumping into their puts while they remain expensively priced on a relative basis. The volatility indices have pulled back from their recent highs but remain above single-digit territory, which has pointed to market downdrafts in the past.

In my opinion, the market is faced with what could be a huge opportunity for a big breakout. The cautious sentiment that blankets the Street leaves the door wide open for companies to positively surprise investors with their earnings reports. On the heels of a stronger-than-expected employment report that came with revisions higher in previous months, perhaps the consumer is not in as in bad as shape as feared by many on Wall Street. This sets the stage for positive surprises in consumer spending, which hints at negative earnings revisions potentially being too dramatic, since the consumer is the ultimate engine of economic growth.

The market bounced back last week, managing to mostly shrug off a weak employment report on Friday. The Dow Jones Industrial Average (DJIA) finished the week with a gain of 1.3 percent, while the S&P 500 Index (SPX) tacked 1.1 percent. Even the Russell 2000 Index (RUT) put in an impressive performance, as the small-cap index trekked nearly 1.3 percent higher. At the bottom of the heap, (and at no great surprise) is the tech-laden Nasdaq Composite (COMP), which finished slightly lower on Friday and up only 0.8 percent for the week.

There a number of similarities between the recent decline the market and the one that occurred in May 2006. Both drops were close in magnitude, though the 2006 decline was longer in duration. The concerns centered around the 2006 decline were the same as they are now, namely, slowing growth due to worries about liquidity.

Overall, traders have responded to the 2007 decline with overwhelming pessimism. The 10-day moving average of odd-lot shorting activity has not only taken out its second-quarter 2006 level, but it is now resting at its highest level in more than six years. This spike in shorting activity comes as the indices test longer-term support. Such activity might exaggerate declines but it also represents future buying power that can help support an advance.

On the options front, put trading has been extremely heavy. In looking at the put/call volume ratio for all stock and exchange-traded fund (ETF) options across the front three months options, we have seen 11 straight trading sessions of readings above 1.0. This is by far, the longest consecutive days streak going back to 1999.

Moving in for a closer look, we find that more than 695,000 put positions were added to the iShares Russell 2000 Index (IWM) from Thursday March 1, though Thursday, March 8. As a result, the ETF’s Schaeffer’s put/call open interest ratio (SOIR) has popped back above 2.0. Meanwhile, the Standard & Poor’s Depositary Receipts (SPY) added roughly 546,000 puts during the same time frame, lifting its SOIR to 1.91 ? its highest level since February 28.

This wealth of put activity in these ETFs is mind-boggling, especially within context of CBOE Market Volatility Indices (VIX/VXO) being 50-100 percent higher during the course of the past couple weeks. In other words, investors are buying portfolio insurance en masse at exorbitant prices relative to late January.

However, despite the modest rebound from last week, we’re not seeing the “buy the dips mentality.” Think back to all the financial media articles and analysts on the various TV programs you’ve seen during the past week. How many dozens of people have we seen quoted saying this pullback is the start of something bigger?

Rather, it’s that everyone and their great-grandmother who matters these days has shorts or puts in place, and when the market plunges: 1. They get too short and cover positions, especially on the long put side where premiums get too rich to resist taking at least something off the table. This provides a bid for the market. 2. (A subset of #1) Those who are already short stock or long puts do not bail out on pullbacks - just the opposite. Panics don’t feed on themselves for the same reason rallies don’t feed on themselves - the hedged players create mean reversion. Think about what happens when the VIX moves below 10 - the put buyers jump in and kill the rally. 3. And speaking of put buyers, they step aside until the VIX comes back in, thus lifting selling pressure.

Technically speaking, it was encouraging to see the SPY rally back above the 140 level after the “catch” at its 160-day moving average. Furthermore, we are headed into another option expiration week, which has historically proven to be a positive week for the broad market. (Click here to read more about expiration week)

Currently, the SPY has more than 255,000 puts open in the March 135-138 strikes. The IWM has approximately 500,000 puts open in its March 74-77 strikes. Should the ETFs remain above these strikes, the unwinding of the hedged positions could provide the market with a fresh lift during the next week.

Stocks bounced back. It was a solid week on the Street for equities last week, as the S&P 500 Index (SPX) jumped 1.6 percent, ending just shy of a new multi-year high. What’s more, the Nasdaq Composite (COMP) soared 2.8 percent, closing above the 2,500 level for the first time since February 2001. The tech sector remains a hotbed of strength as we continue to see rotation out of oil-related securities and into tech stocks. Speaking of oil, crude remained on the downward slope, as the February futures contract shed six percent for the week and is down approximately 13 percent since the start of 2007.

Looking ahead to this week, we find the market poised for what could be a very good week for stocks. One reason for broad-market strength is the simple fact that we are once again approaching options expiration. During all of 2006, the Standard & Poor’s Depositary Receipts (SPY: sentiment, chart, options) finished only three expiration weeks in negative territory, while the average return during the week comes in at a gain of 0.62 percent. Below I have list the weekly gains for the SPY during expiration week.

“I think one potential reason for the upside bias in expiration weeks is the unwinding of heavy out-of-the-money puts that accelerates during that week. As these out-of-the-money puts are bought back to capture what little time value is left, those who took the other half of the trade and sold the puts are able to buy back the SPY shares they sold as a hedge against the short put position. This unwinding action in turn helps to add buying pressure to the SPY during this week.”

Furthermore, options players are adding to this argument, as traders continue to focus on the exchange-traded fund’s puts. On Thursday, open interest at the trust’s out-of-the-money strikes grew and continued to see brisk trading throughout Friday.

In addition, put open interest for the S&P 100 Index (OEX) continues to swell. On Friday, the Schaeffer’s put/call open interest ratio (SOIR) for the index jumped from 1.48 to 1.59, as roughly 1,300 call positions were liquidated and nearly 12,000 puts were added. This reading is now just seven percent shy of hitting a new annual high. However, this isn’t the start of the trend for the index’s SOIR. The ratio has steadily climbed from a near-term low of 1.37 on January 8 to its current perch, as puts are added at a faster pace than calls. The hefty accumulation of puts at the 660 strike for the OEX leaves the index well supported and seemingly bullishly positioned.

Technically speaking, OEX rallied back to resistance at the 665 level on Friday. This region hindered the index’s advance on January 3 and on December 18. My sense based on past such situations is that if 665 is taken out we could get to 670 very rapidly.

Turning back to the technology sector for a moment, Apple (AAPL: sentiment, chart, options), IBM (IBM: sentiment, chart, options), and Google (GOOG: sentiment, chart, options) are facing round-number resistance and big call open interest at 100, 100, and 500 strikes, respectively. It will be very interesting to see how this plays out by this Friday’s expiration. As if to add more fuel to the fire, Apple is scheduled to report earnings on Wednesday, January 17, and IBM will post its results on Thursday, January 18.

While I’m no big fan of these names, they could benefit greatly from the natural bullish bias of the market from the unwinding of the various index puts as we approach expiration. And once above the strike, they could benefit from a delta-hedging surge. The latter would depend on whether the open calls were bought to open (delta-hedging possibility) or sold to open (resistance would heighten as the stock rallies further above the strike due to selling of shares by those long the calls).

However, the market does face a couple potential obstacles. One would be the 800 level for the Russell 2000 Index. This round-number region has hindered the small-cap index’s rally attempts since early December.

A second obstacle is the 10 level for the CBOE Market Volatility Index (VIX – 10.15). Since November, broad-market rallies have have stalled when the VIX has moved into single digits, and we are only a few ticks away from these levels as of Friday’s close. I expect the market to ultimately begin accepting single-digit VIX readings as simply a reflection of the underlying low level of realized volatility, rather than as a sell signal or as a signal to buy “cheap” puts. But for the short term, the market faces a challenge every time the VIX sports a “nine-handle.” Perhaps the best prognosis for this expiration week would be a quick and sharp pullback on Tuesday that pops the VIX back toward 11, and then a steady rally during which the VIX pulls back grudgingly toward 10.

On the options front, the Standard & Poor’s Depositary Receipts (SPY: sentiment, chart, options) closed Friday just above the 140 strike, which is the site of peak put open interest in the January series with more than 75,600 contracts. This strike corresponds with round-number support at the 1,400 on the SPX, which is also the site of healthy put open interest (119,100 contracts). This accumulation of bearish bets could help to serve as a layer of key options-related support for the broad market.

Technically speaking, the 50-day moving average for the SPY rests just above 140, which many technicians may be focusing on during the short term. A break of these key option-related areas and popular moving averages could lead to accelerated selling like we saw in May 2006, which is something traders should be on the alert for.

However, if past is prologue, the higher probability scenario is that these option-related support areas hold.

The same story exists for the iShares Russell 2000 Index (IWM: sentiment, chart, options), which breached its 50-day moving average last week. The exchanged-traded fund (ETF) is currently trading right around major put open interest at the 75-77 strikes. We look for the areas to ultimately hold during the short term.

Another bullish argument for strength in IWM is the growing pessimism exhibited in the steady increase in the ETF’s Schaeffer’s put/call open interest ratio since December options expiration. During that time frame, the ETF has seen roughly 550,000 puts added compared to only 175,000 call additions. This swelling of bearish bets has certainly has put a huge brake on IWM action during this period, and an unwinding could be huge in the other direction as we now turn the corner toward expiration.

Meanwhile, NYSE market breadth (as measured by the advance/decline ratio on NYSE stocks) reached its most over-sold level of the past three weeks on Friday. Oversold can always get more oversold, but there is potential for Friday’s action to be climactic, especially combined with pullback to the support levels cited above.

One other indicator that deserves mention is the CBOE Market Volatility Index (VXO), which is based on S&P 100 Index (OEX) options. Could the index have finally reached a peak last week, as its advance coincident with the broad-market sell-off? The index is nearing its 160-day moving average, which marked a peak for the VXO during its last rally attempt.

This rise in the VXO essentially means that portfolio protection is becoming more expensive for options traders. In fact, it is nearly 50 percent more expensive than in mid-December when the market peaked.

When the implied volatility of options is low, it attracts the “portfolio protection play” because puts are cheap and (usually) because the market has rallied, and the perceived “need” for protection becomes more intense due to the mean-reversion mentality among traders. This activity tends to put a lid on the market, as the put sellers on the other side of the trade short futures as a hedge.

However, when the VXO has rallied sharply, the protection play is discouraged by the fact that it has become more expensive, and by the mean reversion mentality that looks at pullbacks as buying opportunities (just as rallies are looked at as selling opportunities).

The increased expense of buying put protection may now cause some portfolio managers to shy away from purchasing puts thus helping the market find support.

Furthermore, any downturn that might emerge during the short term could be led by commodity-driven sectors, similar to the pullback we witnessed in May 2006. We continue to avoid this area of the market, even though traders might be attempting to bottom fish following the huge sell-off in these areas we saw at the start of the New Year.

In addition, the 2007 Nasdaq/tech rally could be fueled in part by a move by the hot money out of commodities and into what is perceived as the next hot sector. In fact, while the SPX notched a loss for the week, the Nasdaq Composite (COMP) added 0.79 percent. However, this could be a sucker move unless and until a real breakout occurs. The weekly relative-strength measure for the Nasdaq-100 Trust (QQQQ: sentiment, chart, options) versus the Select Sector SPDR Energy Fund (XLE: sentiment, chart, options) has climbed into resistance at its 80-week moving average. The tech sectors are also vulnerable due to its high ranking in most year-end forecasts and high expectations for upcoming fourth-quarter earnings.

Stocks endured another choppy week of trading, as the S&P 500 (SPX – 1,380.90) got a boost from technical support on Monday, and then spent the rest of the week spinning its wheels. As mentioned last week, the SPX and other major indices were in a must-win situation, as they were in the process of challenging key support levels. Without an early bounce in stocks, chances increased that short-term profit-taking would change into short-term bearish conditions for stocks. Despite the bounce seen last week, stocks still face an uphill battle to keep the bullish streak alive, as sentiment continues to suggest some upcoming weakness and the technical picture remains murky.

As I said last week, sentiment has been creeping toward more bullish readings as stocks make their way through what is frequently termed a seasonally strong period. One of the more successful long-term sentiment indicators is the Chicago Board Options Exchange (CBOE) equity put/call ratio. The trend in this ratio often tips the hand of options investors, as it signals whether this crowd is becoming more bullish or bearish, and thus whether cash is flowing into or out of the market. Over the past two weeks, this ratio has been signaling that the market’s cash flow is shifting from coming in to going out. In other words, according to the trend in option volume traded on the CBOE, the market is potentially facing some headwinds, as investors begin to apply selling pressure to the market.

The volatility indices (which measure relative fear among options traders) continue to reflect a mixed market, as some are hitting relative lows while others have farther to travel before hitting their low point. The VIX (10.79) and VXO (10.61), volatility indices for the SPX and S&P 100 Index (OEX – 643.32), spent the week trolling at the bottom of their ranges while the market moved a little higher. A simple analysis of these fear gauges implies that the market should begin bumping against a ceiling. Comparatively, the volatility index for the Nasdaq 100 (NDX – 1751.11), the VXN (15.52), broke through the bottom of its recent range last week and is now moving lower. Given that a volatility index tends to move in a direction opposite to its associated index, the current status of these indices suggests that the Nasdaq has the least congestion above its current prices and should outperform if the market continues to move higher.

As we head into options expiration week, I should point out that such weeks normally produce some significant moves in the major indices. I’m also reminded that major stocks and indices tend to be “pinned” at or near strike prices that hold significant call or put open interest. We also tend to see more exaggerated support from peak put strikes. With this in mind, a quick review of Friday’s peak put open interest strikes for some major ETFs is appropriate: Nasdaq-100 Trust (QQQQ – 43.02) – 42; S&P Depositary Receipts (SPY – 138.24) – 136; Diamonds Trust (DIA – 121.11) – 120; and iShares Russell 2000 Index Fund (IWM – 76.52) – 75. Should the market see some early weakness this week, these ETFs will likely encounter support at these price levels, as the mechanics of these put options begin to attract trading activity. Looking forward to December, peak put strikes for QQQQ and DIA remain the same, while SPY peak put open interest drops to the 135 strike and IWM’s ticks up to the 77 level.

Wrapping it up, while expiration week trading will likely add some volatility, this week’s slew of economic reports should have a bigger impact. Consider the market outlook as cautiously optimistic, as the major indices remain above short-term technical support (the 20-day moving average). However, a move below this trendline will come at a cost, as the market will likely incur more prolonged selling due to building optimism and recent price activity that is showing some signs of weakening.