Are Bulls Getting Ahead of Themselves?

The rise in speculation and bullish sentiment may have a lot to do with the aggressive moves by the Fed

From Standard & Poor's Equity Research

Note: This story was originally published on Standard & Poor's MarketScope on Oct. 11, 2007.

A funny thing happened on the S&P 500's way to 1600. Market sentiment has quickly started to exude confidence, and while these measures of emotion many times precede intermediate-term tops by a month or two, it is certainly not a good time to relax and get too complacent.

We have previously written that we thought that the stock market might have the wind at its sails into January, 2008, due to the strong seasonal effect that many times runs during November, December, and January. During bull markets since 1970, it has been rare to see intermediate-term declines that start in November or December because of the positive seasonal bias. This has now been put into question, as enough of our sentiment indicators have moved quickly to the bullish camp, and these indicators have many times led intermediate-term peaks by four to eight weeks, which puts us into the middle of November to the middle of December.

One potential which would satisfy both sentiment and seasonal forces, in our view, would be a strong move into mid-November/mid-December, followed by a market that slowly grinds higher into January, but makes little progress. We have seen this type of intermediate-term top in both 2006 and 2007.

We still believe that the market has more upside and think the "500" has a good shot of reaching the 1600 to 1650 area before the end of the year. We are just unclear about when the forecasted top will be. Price volatility has plummeted over the last 3 weeks and the S&P 500 has been in a very consistent uptrend over that time. In our view, we are in the sweet spot of an intermediate-term uptrend. The timing of a top has a lot to do with the velocity of price.

No, we are not going to give a physics lesson. If we get an upside blowoff, we think the intermediate-term top could come fairly quickly, and this would take the market farther than we are expecting. If the market advances in a nice consistent manner, and the slope of the rise does not become too steep, then we think the timing could extend into the latter parts of 2007 or into early 2008.

Another thing to watch for if we are approaching a peak in prices is a pickup in volatility. Many times as the market is topping, institutional distribution becomes more prevalent and this shows up in higher price volatility as supply catches up with demand, and you get a real tug of war between buyers and sellers.

So where have all the bulls come from? Or just as curious, why did we all of the sudden see a pickup in speculation and bullish sentiment? While we may not know the answers, we surmise that it had a lot to do with the aggressive moves by the Federal Reserve, and the very positive price action of the global stock markets. Quite frankly, we don't really care where the bulls are coming from or why sentiment jumped recently, but we care more that it has happened and how it affects our stock market outlook.

One of the most accurate sentiment/speculative gauges we monitor is the ratio of Nasdaq volume to NYSE volume. The idea of this indicator is too measure when speculation is high or low. When Nasdaq volume rises in relation to NYSE volume, we believe this is a good indication that speculation is rising as the higher beta issues generally reside on the Nasdaq, and the stodgy blue chips are more likely to trade on the NYSE.

One of the ways to see if speculation is rising is to look at the 3-week average of Nasdaq volume to NYSE volume. Over the last four years, this ratio has tended to oscillate between 110% and 140%. We designate extreme readings above and below this range. The current reading as of the end of last week was 152%. Not counting the present reading, we have seen this ratio rise to 140% or above on five occasions since the beginning of 2004. Each time preceded an intermediate-term top by four to eight weeks. Observing this data on a daily basis gives us a similar predicament. When the ratio has risen to 150% or above on a daily basis, it represented a good warning sign that a top was approaching.