Slow and steady won the race for the bulls last week. Three successive sessions of topsy-turvy price action, defined by sizable pullbacks and near-breakeven closes, finally culminated on Friday with solid gains. The Dow Jones Industrial Average (DJIA) rose 1% on Friday and tacked on 2.1% for the week. The Nasdaq Composite (COMP), which underperformed its peers mid-week, surged nearly 2% higher on Friday to end the week with a 2.9% gain. And the S&P 500 Index (SPX) gained 1.4% in Friday's session and 2.3% for the full week. Finally, the Russell 2000 Index (RUT) moved up 1.9% on Friday and closed 2.8% higher for the week.

These gains occurred despite a wide selection of challenges ... from record-high crude prices to disappointing Amazon.com (AMZN) earnings and Merrill Lynch's (MER) larger-than-expected write-down figure, to mixed housing sales. Post-expiration week since January 2006 is now moving toward a coin flip between negative and positive returns; taking last week's positive close into account, 12 of the past 22 post-expiration weeks have been negative.

The major indices' weekly gains helped take them back above some critical thresholds that again serve as support. The Dow is back above 13,500 (but continues to look up at the 14,000 mark). The SPX bounced from support at its 80-day and 160-day moving averages and remains above the critical 1,500 mark. The SPX also managed to close above its March 2000 weekly closing peak of 1,517.68. And the S&P Depository Receipts (SPY) enjoyed mid-week support from its 32-week and 40-week trendlines. The S&P 100 Index (OEX) looked at risk of breaching the 700 level but closed solidly north of this century level.

Moving to techs and small-caps, the RUT headed back above the 800 level and the COMP hurdled the 2,800 mark with the help of a monster rally in Microsoft (MSFT) on Friday following blowout earnings. Both of these levels have been speed bumps to watch in recent weeks, and the 2,800 level has historical significance to boot. As Todd noted last week, the COMP managed just 4 closes beyond the 2,800 mark in 2001 before a steep plunge began. Friday's close above 2,800 marked number four since October 9.

On the sentiment front, we're seeing a mixture of caution that skews toward bearishness, as well as some complacency, but on balance the picture bodes well for the market from our contrarian perspective. The sentiment as reflected in the financial media leans strongly toward the belief that this market is in for a "comeuppance," along the lines of the peaks in 2000 or in 1987. But one critical difference between these past market peaks and now is, ironically, this very air of caution. Before the bubble burst in 2000 complacency nay, euphoria was palpable, and the "wall of worry" was nonexistent. For example, in 2000 as certain indicators pointed to recession, phrases such as "New Economy" and "This time is different!" predominated and the Nasdaq Composite soared to an astounding 83% above its 80-week moving average. In 1987, investors were so confident that the uptrend was going to continue indefinitely that they flocked to put options not to buy them for downside protection but to sell them to earn extra "income." These days the various risks to the market and the economy are continually emphasized and rallies are very well contained, with the S&P currently just 9% above its 80-week moving average.

Today's wall of worry has several more layers, including one constructed by the nation's small investors. The latest poll from the American Association of Individual Investors (AAII), which queries its 150,000 members weekly, showed a very high reading of bears, at 48%. Our quantitative analysis department looked back at past AAII survey readings where the bearish total exceeded 45% dating back to 2000. Eliminating duplicate signals within a 30-day period, the study yielded 17 results.

Subsequent to these 17 signals the S&P returned, on average, 4.02% in the next 40 trading days. This compares to an at-any-time 40-day return of 0.32% in the S&P since 2000. The 10-day, 20-day, and 60-day S&P returns were also quite favorable following such steep bearish readings from AAII.

Short interest on the New York Stock Exchange continues to build and is now near another record-setting high, at 11.6 billion shares at the end of the October reporting period. Since mid-2006, the number of Big-Board shorts has been in sharp uptrend mode, rising roughly 70%. A growing and ongoing "short trade" will cap rallies due to the continual supply offered by short sellers (and thus prevent the upside from getting out of hand) and will support pullbacks due to short covering. Plus as an extra added "bonus," the shorts will periodically panic out of their positions on rallies and create the short-covering "explosions" that can be so profitable for the bulls.

The options-trading collective is also exhibiting some caution, with the Schaeffer's put/call open interest ratio (SOIR) for the S&P 500 at 1.83. Out-of-the-money puts are in vogue, most notably at the November 1300, 1400 and 1500 levels, all of which have more than 100,000 open contracts in play (I guess these guys like round numbers). And this "sky is falling" sentiment isn't contained to just the front month; the majority of put open interest in the December and January series resides significantly out of the money, implying the portfolio-protection trade is extremely popular. As is the case with heavy short interest, a big put protection trade will tend to be very supportive for the market on pullbacks.

We do continue to have concerns on the volatility front, with the CBOE Market Volatility Index (VIX) still 8% above its 32-week moving average. But the VIX did end the week below the 20 level, which has been an important round number for most of the year.

But the bottom line is that a backdrop of caution and bearishness ultimately helps the market bounce back from "bad news"-based pullbacks such as those we saw last week surging oil, broker write downs, etc. because expectations are modest, so good news (Microsoft earnings) sets the buyers ablaze and sends the shorts and the put buyers scrambling to cover.

Speaking of expectations ... this week, we have another Federal Open Market Committee (FOMC) meeting. The fed funds futures market points to another 25-basis-point rate cut, and if Bernanke's coterie doesn't deliver, the market is certain to endure some short-term pain. The rate decision is scheduled for Halloween afternoon. Aside from that, earnings season motors on, with results expected from Procter & Gamble (PG), Exxon Mobil (XOM), Sirius Satellite (SIRI), and others. The employment report rounds out the week on Friday, and we'll also bid adieu to October and welcome the penultimate month of 2007 and a seasonally strong final two months of the year.

And now a few sectors of note...

Dissecting The Sectors

Sector

Base Metals/Copper Bullish

Sentiment: Our favorite trio of names from the copper sector -- Southern Copper (PCU), Freeport McMoRan Copper & Gold (FCX), and BHP Billiton (BHP) -- continue to test new highs. Short-term moving averages continue to support the shares as well, which have trended higher for months along their respective 10-day and 20-day trendlines. But the threesome has yet to earn the full respect of Wall Street. Currently, there are 13 total "buy" ratings among the 3 stocks and 13 "holds." Additionally, in the wake of options expiration, the speculative crowd remains rather bearish on BHP and FCX, and short sellers have made healthy bets against 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 continue to favor PCU, BHP, and FCX as ways to capitalize from the health copper sector. All 3 stocks look exceptional from an Expectational Analysis standpoint; they have been steadily moving higher, and all have potential buying power waiting on the sidelines in the form of short covering, bearish options unwinding, and prospective analysts' upgrades. Meanwhile, long-term copper futures jumped higher last week and are a hair's breadth away from overtaking their 10-day trendline.

Sector

Small-Cap and Mid-Cap Momentum Bullish

Sentiment: Options players are hedging their bets against the small-caps; out-of-the-money put positions in the November series are remarkably heavy. For example, the November 80 put, which is out of the money by $2, is home to more than 360,000 open contracts. This bearish speculation continues through the December and January series as well. While options activity is considerably less active on the S&P 400 MidCap Index (MID), the index's Schaeffer's put/call open interest ratio (SOIR) stands at 1.66, indicating the presence of 166 open puts for every 100 open calls in the front three-months series.

Outlook: As I have repeatedly pointed out in this space, small-cap stocks, collectively represented by the Russell 2000 Index (RUT), should have the momentum to drive a broader-market rally forward over the near term. The index has regained control of the 800 level and its 10-day moving average. The MID, meanwhile, has also powered higher of late to overtake its 10-day trendline. Look for small- and mid-cap names that are displaying solid momentum, such as Overstock.com (OSTK), Illumina (ILMN), and Chipotle Mexican Grill (CMG).

Sector

Financials Bearish

Sentiment: The Schaeffer's put/call open interest ratio (SOIR) for the Select Sector SPDR Financial Fund (XLF) continues to decline, as complacency builds among the speculative crowd. Currently, the indicator weighs in at 1.80, a new annual low. The composite SOIR for the brokerage sector, meanwhile, has edged slightly higher to 0.22, in the 9th annual percentile. The banking group's composite SOIR is closer to the pessimistic end of the spectrum at 0.92 (the 86th annual percentile). Short interest on both the banking and brokerage groups has declined in recent months, pointing to declining caution among equity investors.

Outlook:Brokerage and banking names remain vulnerable to subprime exposure, a weak housing market, and the overall credit crunch. The XLF continues to underperform the broader market on a relative-strength basis and remains wedged below its 10-week and 20-week moving averages. Given Merrill Lynch's (MER) poor turn in the earnings confessional last week, the worst may not be over for the financial group.

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

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