Last week's roller-coaster ride left many investors clutching their stomachs by the close of trading on Friday. Thursday saw the market post a sharp pullback on no specific news other than a false rumor of a downgrade of tech stocks by a major brokerage firm. However, despite Thursday's weakness, the major market indices notched yet another positive week. The Dow Jones Industrial Average (DJIA) jumped 0.56 percent and the S&P 500 Index (SPX) edged 0.48 percent higher. The tech-rich Nasdaq Composite (COMP) was the big winner with a gain of 1.21 percent for the week.

The strength of the rally has pushed the SPX above the 1,537 level, which is double the index's 2002 low. This "doubling area" served as a major speed bump in May through July, halting the SPX from reaching new all-time high territory. It is often the case that such resistance emerges after stocks or indices approach a doubling point, as this serves as an impetus for profit taking. Similarly, the Dow is facing potential resistance in the 14,400 region, which is roughly double its October 2002 low of 7,197.5.

Turning to the Nasdaq, the index succeeded in closing above the 2,800 level last week as it consolidates into support at its rising 10-day moving average. In fact, the index closed four out of the past five sessions above the 2,800 level. Note that in 2001 the COMP managed only four closes above the 2,800 level in January 2001 as it peaked at 2,894.4 before plunging sharply. So the 2,800 level bears close watching as a potential Nasdaq speed bump.

Furthermore, it's now crunch time for small caps. The Russell 2000 Index (RUT) logged a loss of 0.44% last week as it failed to bounce back from Thursday's beating. The index must still take out resistance at the 850 level, which stopped its ascent from late May through July. In addition, I would like to see the RUT's September relative-strength low versus the SPX now followed by a higher relative-strength high, which would go a long way toward breaking the downtrend.

Finally, the CBOE Market Volatility Index (VIX) bounced off support at the 16 level last week to finish slightly above its 32-week moving average. The rally by the VIX back above this important trendline on a weekly closing basis creates additional risk for the market.

These short-term concerns aside, looking ahead to the remainder of 2007, the market is poised for a strong rally as hedge funds desperately attempt to make up for lost ground. While hedge funds rebounded in September after breaking a 13-month string of positive returns in August, they are still lagging behind the major market indices. With the year winding down, hedge funds find themselves running short on time to catch up with the broad market. As hedge funds increase their long exposure to capture more gains, they will help to feed the ongoing rally in stocks.

Meanwhile, bullish sentiment on the Street is still far from a peak. In fact, cumulative analyst "buy" recommendations continue to hover close to 2002 lows, while the market has nearly doubled in value during this time frame. This lack of optimism from Wall Street leaves the door wide open for upgrades to fuel fresh gains among stocks.

What's more, average strategist allocation to stocks is actually on the decline amidst this uptrend. Allocation levels dropped in early June and have yet to recover, lingering close to 64 percent. Yet, when the major indices were tagging new highs in 2000, the recommended equity allocation was well above 70 percent. With Wall Street not fully invested in the market's rally, there is still opportunity for buying pressure to increase should the brokerage firms begin to capitulate and raise their equity allocations.

This week, we see earnings season take off, as a large number of major firms step into the earnings confessional. Tech stock will be in focus in particular with Google, Yahoo!, IBM, and Advanced Micro Devices all slated to release the quarterly results. With many analysts lowering their earnings estimates, there is a heightened chance for positive surprises as these companies step forward.

In economic news, the Street will receive a valuable peek at the state of inflation in the nation with the release of the Consumer Price Index (CPI). Furthermore the Fed's Beige Book will hit the Street this week, providing a look at the state of the economy. This key report will help set the tone for the upcoming Federal Open Market Committee meeting at the end of the month.

Elsewhere, one psychological stumbling block arrives this week in the form of the 20th anniversary of the stock market crash on October 19, 1987. With this in mind, I prepared the following answers to some "crash questions" posed to me by one of my colleagues at Schaeffer's Investment Research.

1. What lessons from the stock market crash of 1987 can we use today?
It's always helpful to realize that the stock market can go "off the rails", which should be kept in mind by all investors who are considering taking on too much equity exposure and ignoring the downside risks.

2. What are the key parallels between the pre-crash market of 1987 and today's market?
It is October and it is a year ending in a "7" and it is a pre-election year, which is much more coincidence than parallel. Also, the dollar was weak then and is now and a relatively new Fed Chairman then and now. Some "unparallels" - interest rates were rising then and are falling now, the market topped in August 1987 while it bottomed in August 2007.

3. What are the key differences? Is the market more resilient now? If so why?
There is a huge portfolio protection trade in 2007, in part the result of the spectacular growth in the hedge fund industry as well as 130/30 funds and "market neutral" funds. This protection trade consists of long positions in index and equity put options and short positions in stock index futures and in individual equities. This means that the market is a lot more resilient now than it was in 1987, as it is to a larger extent "pre-sold" in anticipation of potential disaster. The situation in 1987 couldn't have been more polar opposite. Players were selling puts rather than buying them because the market was believed to be in a perpetual bull mode. And downside protection was in the form of "portfolio insurance" based on the mistaken concept that portfolio protection (in the form of short positions in index futures) could be added in increasing amounts as the market declined. In fact, this only aggravated the market's decline in 1987, as would-be "portfolio insurers" all tried to short the market at the same time.

4. Could the crash happen again? What would it take?
Anything can happen in the stock market, but it is just silly to fear a market crash in October 1987 just because one occurred 20 years ago in the same month. For a full blown crash to now occur would require a serious exogenous geopolitical event such as a major terrorist attack on US soil, or a huge financial accident probably emanating from the credit markets.

5. What should investors do if they are worried?
Stock market investors should always be worried, in the sense that they should realize that stocks are not always "safe" and that they should never have excess exposure to the fluctuations of the stock market relative to their net worth and to their tolerance for risk. If you fear your exposure is excessive, you should simply pare it down as opposed to going off and buying put options and shorting stocks, strategies that have been a huge challenge even for professional investors. Bear in mind also that historically those periods where investors have been most worried have generally proven to be good buying opportunities.

While roadblocks may be looming overhead for the major indices crash fears may come to the forefront this week, the wealth of pessimism that continues to blanket the Street and the growing need among the hedge fund managers to improve their lagging performance leaves this market poised to continue its impressive rally.

(Correction: The weekly percent change for the Russell 2000 Index was incorrectly reported as a gain. The percentage has been updated to show a loss for the week.)

And now a few sectors of note...

Dissecting The Sectors

Sector

Base Metals/Copper Bullish

Sentiment: Three of our favorite copper names - Southern Copper (PCU), Freeport McMoRan Copper & Gold (FCX), and BHP Billiton (BHP) continue to trend upward into new-high territory. But the trio still stands to benefit from upgrades on Wall Street. Currently, there are 13 total "buy" ratings among the 3 stocks, 12 "holds," and 1 "strong sell." Additionally, options players have assumed a relatively bearish position on BHP and FCX, while short sellers are active on FCX and PCU. The grouping of stocks remains attractive from a contrarian perspective as it epitomizes the combination of strong price action against a backdrop of skepticism.

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, all have potential buying power waiting on the sidelines in the form of short covering, bearish options unwinding, and prospective analysts' upgrades. Meanwhile, copper futures remain in a strong uptrend as they consolidate into support at their ascending 20-day trendline.

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 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 0.65. While the absolute number doesn't look particularly bearish, this reading is higher than all but one of the readings taken during the past 52 weeks.

Outlook: Technically speaking, as the StreetTRACKS Gold Trust (GLD) continues to climb higher due to strength in crude oil, weakness in the dollar, and concerns surrounding the strength of the economy. The exchange-traded fund (ETF) has risen steadily along its 10-day moving average, while the price of the underlying metal is now resting near 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) continues to reflect a sense of complacency among the speculative crowd. Currently, the indicator weighs in at 2.03, which is lower than all but two percent of the readings taken during the past year. The composite SOIR for the brokerage sector, meanwhile, stands at 0.12, lower than 90% of the past year's readings. The banking group's composite SOIR is closer to the pessimistic end of the spectrum at 0.92 (the 88th annual percentile). Short interest on both the banking and brokerage groups has declined in recent months, pointing to building optimism among equity investors.

Outlook:While the rising tide of the market has helped lift the XLF in recent weeks, the group isn't out of the woods yet with regard to subprime exposure and the overall credit crunch. The ETF continues to underperform the broader market on a relative-strength basis and has yet to break through resistance in the 36 area. With earnings season now in focus, reports from banking and brokerage names will provide more of a clue into the true bottom-line impact of the recent credit-market woes.

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

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