It seems as though I owe Mr. Bernanke an apology. Last Monday, I opined that "it is becoming increasingly clear to me that a minimum of a 50-point cut is needed and that Bernanke is not likely to deliver on it." What do you know, the rookie Fed Chief and his FOMC cohorts made an uncharacteristically aggressive move that surprised the skeptics (and yours truly). Fifty basis points were knocked off the fed funds rate, the markets immediately rejoiced (as I would have expected), and the major market averages tackled levels not seen since late July.

After pausing briefly to catch its breath on Thursday, the Dow Jones Industrial Average (DJIA) finished in the black again on Friday and closed 2.8% higher for the week, edging through the 13,800 threshold. The S&P 500 Index (SPX) gained 2.8% on the week as well and closed above its 10-week and 20-week moving averages for the first time since July 20. What's more, the market continued its string of positive expiration weeks. Since January 2006, the Standard & Poor's Depositary Receipts (SPY) have finished expiration week with a loss only six times out of 21 expirations. The Nasdaq Composite (COMP), meanwhile, ended the week with a gain of 2.6% and retook control of the potentially supportive 2,650 level.

But of course you all already know all of that. With the rate-cut mystery solved for the time being (we're now left to sort through conjecture on the two meetings remaining until the end of the year), the market can continue in earnest the recovery from its August nadir, which was defined by climactic pessimism. Weeks later, this pessimism continues to unwind, as exemplified by the price action of the CBOE Market Volatility Index (VIX). Last week, the fear barometer declined nearly 24% and closed below its 80-day moving average and its mid-March peak (21.25).

What's more, the VIX ended Friday beneath its 20-week moving average for the first time since April 20. Intrigued by this behavior, our Quantitative Analysis group looked back 10 years to see the short-term implications of a drop by the VIX below the 20-week after a period of 10 weeks or more north of this trendline. Since 1998, this particular phenomenon has occurred only 7 times, and each time, it has enjoyed bullish implications. In fact, the returns are quite good when compared to the market at any given time, and the signal has been consistent (the standard deviation of the returns are lower than that of the market in general). For example, the last time the VIX made such a move was on May 13, 2005, and the SPX gained a respectable 4.05% during the next 20 trading days, while the average gain in the index during a 20-day period is only 0.45%

Speaking of signals, I'd like to briefly follow up on one that was generated in late August. On occasions where the VIX jumps 50% and then shifts back below its 20-day trendline, the market has been higher almost 95% of the time one month after such an occurrence. This bullish signal was triggered on August 22 when the SPX closed at 1,464.07. One month later September 21 the SPX closed at 1,525.75, up 3.7%.

Decreasing volatility ostensibly makes the act of premium selling less attractive. Premium selling has been rampant in recent years, but the market turbulence over the past several months has challenged put sellers and covered call writers, respectively.

Will the option sellers be back in force as the market is perceived to settle down, even though this means the premiums captured will be diminishing? Or are these players still licking their wounds and out of the game for a while? If the latter proves true, the impact of the strike "speed bumps" that I've discussed on several occasions becomes much less pronounced, which helps premium buyers by diminishing the "gravitational pull" of option strike prices. But one must also expect that this contraction in option premiums will become attractive to long put players, either speculating on a decline or hedging their portfolios. However, the impact of hedging with long puts or short futures or ETFs which keeps rallies in check but also creates support on pullbacks is easier to stomach for those of us looking to profit from big directional moves than are the maddening pauses at almost every strike that had been created in recent years by the option sellers.

I'll reiterate what I said last week: "I believe many ingredients are in place for a sharp rally off what may have been a major market bottom in August." And another positive intermediate- to long-term sign is the continued pessimism perpetrated by the nation's media, emphasized by headlines such as "Did the Fed Panic?" (9/19 Wall Street Journal); "US Stocks Outlook: Longevity Of Market's Euphoria Questioned" (9/18 Dow Jones newswire); "Rogers, Faber Say Fed Rate Cuts Will Spur a Recession" (9/18 Bloomberg); and "Housing Slump May Produce a Recession" (9/19 Associated Press). The argument of the bearish crowd has quickly morphed from "The Fed should not cut rates to save the speculators" (Translation: We want our bear market!) to "The rate cut will not be effective in righting the economy or rallying the stock market and will cause an inflationary surge" (Translation: We still want our bear market!).

Some technical caveats. The SPX is staring down three levels of potential concern. The 1,525 level defined the index's highest monthly close in 2000 (during August) while the 1,530 level marked the SPX's highest monthly close so far this year (in May). Above that is the 1,540 level, site of short-term chart resistance. These levels could be fortified by the resistance inherent in overhead calls; there is hefty out-of-the-money call open interest on the SPY at the 153 strike and above (equivalent to the 1,530 level on the SPX).

The Dow could face a bit of a hiccup at 14,000, and the COMP may struggle with plowing through its July high near the 2,725 mark. But the Russell 2000 Index (RUT) finally toppled the 800 level, as well as its 80-day and 160-day moving averages. If this rally indeed proves to have legs, I believe the small caps will begin to dominate once again, particularly with the 800 level overcome. And my guess is the hedge funds have regurgitated a big chunk of their small cap exposure during the recent turmoil, which means RUT investors might have a lot of fun while the hedgies scramble to re-establish their positions or risk losing even more ground to the S&P bogie.

From a sentiment perspective, options players have quickly defected to the bullish camp, as evidenced by last week's data from the International Securities Exchange (ISE). After the Fed meeting on Tuesday, the call/put ratio (for equities only no index trades), was at 1.15, below its intraday peak, and a relative low ratio (indicating pessimism). But by Friday afternoon, this ratio (again, for equities only) hit 1.99, with calls being bought to open practically doubling puts. This is a sign of short-term concern, if the aggressive speculators behave in an overly exuberant manner.

And for the very short term, remember we're in a week following expiration, which has a slight negative historical bias. Going back to January 2006, 12 of 20 post-expiration weeks have produced negative returns for the SPX.

Looking ahead to the events that market participants will be digesting this week, we have existing home sales tomorrow, followed by new home sales on Thursday. We'll also see earnings this week from homebuilders Lennar (LEN) and KB Home (KBH), but I have to keep asking myself how much more the housing sector can continue to be punished. The final second-quarter GDP will hit newswires on Thursday, and personal income and spending for August will be digested on Friday. Keep in mind that with the end of September marks the end of the fiscal year for the U.S. government and other businesses and organizations. Here's to a prosperous (fiscal) 2008!

And now a few sectors of note...

Dissecting The Sectors

Sector

Base Metals/Copper Bullish

Sentiment: Price action remains strong among our 3 favorite copper names - Southern Copper (PCU), Freeport McMoRan Copper & Gold (FCX), and BHP Billiton (BHP). However, pessimism from investors and Wall Street continues to blanket these outperformers. Analysts have handed the trio of stocks 13 "buy" ratings, 12 "holds" and a "strong sell," meaning future upgrades (or additional broker coverage) could help draw positive attention to the stocks. The options crowd remains bearishly aligned on PCU and BHP, judging by respective Schaeffer's put/call open interest ratio (SOIR) readings of 1.55 (the 92nd percentile) ant 1.46 (the 76th percentile). As for FCX, its Schaeffer's put/call open interest ratio (SOIR) weighs in at 0.66, higher than 69% of the past year's worth of readings.

Outlook: We are staying the course with our positive take on the copper group PCU, BHP, and FCX continue to look impressive from an overall Expectational standpoint. All 3 stocks have been steadily appreciating along 10-day-moving-average support, and all ostensibly have sideline reserves from which to draw additional buying power in the near term. Copper for December delivery soared roughly 6% last week after tacking more than 4% the prior week.

Sector

Gold Bullish

Sentiment: Since the market put in a near-term bottom in August, metals have been one of the best-performing sectors when one month ago the consensus opinion was move into "safety" (health care, utilities, consumer staples). Options speculators have levied some heavy bets against the various gold mining companies recently. The composite Schaeffer's put/call open interest ratio has climbed to 0.52. While the absolute number doesn't look particularly bearish, this reading is higher than 82% of those taken during the past 52 weeks. In other words, short-term options players have been more bearishly aligned against the sector only 18% of the time during the past year.

Outlook: Technically speaking, as the StreetTRACKS Gold Trust (GLD) climbs through its May 2006 highs, trading volume has not been as climatic nor has it been as oversold, indicating that the metal may still have the power to continue its ascent. The exchange-traded fund (ETF) has risen steadily along its 10-day moving average, while the price of the underlying metal is now resting at multi-year highs. Furthermore, the weak dollar and the carry trade (where central banks are forced to buy gold futures to cover positions they have lended) are bullish for the commodity, helping to provide more buying pressure.

Sector

Financials Bearish

Sentiment: The Schaeffer's put/call open interest ratio (SOIR) for the Select Sector SPDR Financial Fund (XLF) bounced back from its annual low last week, but still hovers close by at 3.04 in the ninth percentile. In other words, the options-trading crowd has been more bullishly aligned on the financials group only 9% of the time during the past year. Furthermore, short interest on XLF continues to shrink, as the number of XLF shares sold short dropped by 28% in September. Meanwhile, the ETF bounced back with the rest of the market last week, but is still facing resistance at its declining 20-week trendline. Separating the group between banking and broker/dealer names, it appears as though optimism is greater for brokers. The composite SOIR for the brokerage sector stands at 0.27, lower than 90% of the past year's readings. The banking group's composite SOIR is closer to the pessimistic end of the spectrum.

Outlook: Last week saw a number of brokerage firm march into the earnings confessional with mixed results. While Lehman Brothers managed to surpass expectations, Bear Stearns came up short. From a technical perspective, the ETF must still conquer resistance at its 20-week and 20-month moving averages. A rejection at either of these trendlines or additional negative news regarding credit and/or hedge fund losses could send many of the remaining bulls scrambling for cover, pushing the sector lower.

Copyright Schaeffer's Investment Research http://www.schaeffersresearch.com

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