A VULNERABLE MARKET, SHORT-TERM
by Clif Droke
October 11, 2007

Earnings season is now upon us and with it comes the expectation of greater volatility as both upside and downside earnings surprises are the norm for this period.  This especially holds true for the important cycle that is due to bottom later this month.

There are a couple of concerns I have with the immediate term (1-2 week) outlook.  The first is the overbought nature of the market right now, as shown by the 5-day and 20-day price oscillators for the S&P 500 index (below).  The 20-day oscillator is exceptionally overbought and has hit its highest reading of the year, all the more reason to exercise greater caution in the next few days.

The other concern is the latest investor sentiment survey released by AAII.  The latest poll shows that 52% of investors described themselves as “bullish” compared with only 25% calling themselves “bearish.”  That’s the biggest bull/bear disparity we’ve seen in a few months.  Take a look at the chart showing this gap between bulls and bears.

I realize that in a bull market sentiment as well as the technical indicators can remain in an overbought position for sometimes weeks on end before the market pulls back.  That could theoretically turn out to be the case this time.  With an important market cycle due to bottom later this month, however, and with earnings season now underway, we could be in for a few bumps along the road before we enter the historically prosperous November-December time frame.  

The NASDAQ 100 Index (NDX) keeps trending higher while the Dow has been mostly range-bound in the past few days.  The lack of participation of the Dow, as well as the S&P Midcap Index (MID), the Russell 2000 (RUT) and the Semiconductor Index (SOXX), can be ascribed to the cyclical bottoming process discussed in the previous reports.  

In the next couple of weeks the market will be vulnerable to negative earnings surprises until the sub-dominant interim cycle bottoms.  For safety’s sake, there’s nothing wrong with walking a little slower until the cyclical “danger zone” has passed.

Natural Resources

The Amex Gold Bugs Index (HUI) ended Wednesday’s (Oct. 10) trading session with a gain of 1.72% to close at 405.26.  The XAU index closed at a new high at 176.45 for a gain of 1.74%.  

The CBOE Gold Index (GOX) call/put open interest ratio is still showing more call buying than put buying among the traditionally “smart money.”  The GOX call/put ratio has been the key to the PM stock sector rally from its beginnings in August.  It still hasn’t turned bearish yet as Friday’s reading of 0.23 shows a net bullish stance among the smart money traders.  This shows the psychological backing of the gold stock uptrend to still be intact.

The Amex Oil Index (XOI) closed 1,466 on Oct. 10, and is about to challenge its previous high at the 1,500 area.  There are some bullish patterns showing up in some of the leading oil sector stocks.  Could the oils be gearing up to play “catch up” to the natural gas stocks?

Incidentally, the latest issue of Futures magazine was of interest to contrarian-minded traders.  Guess what was on the front cover?  A bear!  But not just any ol’ bear.  This one was in reference to the energy market.  Could this mean a strong fourth quarter performance for the oil/gas stocks from a contrarian standpoint?  I think it could!