What a Week: Market's Sentimental Journey Takes a Bad Trip Friday

Investors are still buying on bad news, which is historically good for stocks -- even if it all looks so tenuous.
By Robert Mann ,

SAN FRANCISCO -- For much of the week mere hints of stability in the semiconductor space breathed life back into tech stocks. But on Friday, the preceding optimism was looking like another case of investors having put the psychological cart before the fundamental horse.

Xilinx's

(XLNX) - Get Report

comments Monday that order cancellations have slowed and

Intel

(INTC) - Get Report

reaffirming its prior guidance Thursday boosted investor hopes that the chip sector would rebound, providing a potential first step toward a broader tech recovery. Investors even found reasons for optimism amid otherwise disappointing announcements midweek by

Broadcom

(BRCM)

and

National Semiconductor

(NSM)

.

But a revenue shortfall by

Juniper Networks

(JNPR) - Get Report

and a system failure at the

New York Stock Exchange

on Friday conspired to sap investors' confidence, showing just how tenuous that confidence is. Friday's sizable losses also dampened the weekly performance of the major averages. For the week, the

Dow Jones Industrial Average

dipped 0.1%, while the

S&P 500

rose 0.3% and the

Nasdaq Composite

climbed 3.1%.

Even more than usual, the state of

investor sentiment was of

paramount importance this week.

"Market reaction to news is the most powerful indicator we have," said John Bollinger, head of

Bollinger Capital Management

and

EquityTrader.com

of Manhattan Beach, Calif. "Three or four months ago when companies disappointed they were cratered instantly and mercilessly. Now, we find the opposite situation. When companies warn, people are trying to figure out reasons to buy them."

Bollinger believes the 180-degree turn is sustainable and bodes well for equities,

Friday's action notwithstanding. He continues to favor small- and mid-cap stocks vs. large-caps.

But wasn't three or four months ago -- when sentiment was lowest -- the time to buy, suggesting it's time to sell now, because psychology has turned?

No, Bollinger replied, citing three major themes of contrarian investing identified by Humphrey B. Neill, author of

The Art of Contrary Thinking:

Step 1: Identify a widely held opinion.

Step 2: Wait for that opinion to be wrong or inaccurate.

Step 3: Identify a catalyst that will swing the herd.

Although many people are satisfied with step one, Neill doesn't recommend taking a contrarian position until step three occurs, Bollinger noted.

In the current environment, the most widely held opinion is that the economy is going to recover in the second half of the year and that -- based on that expectation -- stocks have been beaten down to levels where there is opportunity.

The outlook for second-half recovery remains murky, at best, judging from this week's economic data, which included a downturn in productivity (and corresponding rise in unit labor costs), slumping factory orders, a record-low non-manufacturing

NAPM

index, sluggish retail sales for May, and another spike in jobless claims.

But the recovery scenario isn't wrong yet, Bollinger contends. Regardless, the catalyst to turn the herd isn't present, as investors continue to put their faith in

Federal Reserve

Chairman

Alan Greenspan

. Thus, many investors paradoxically welcome bad news because it increases the likelihood of more Fed rate cuts.

Circuitous logic, perhaps, but powerful nonetheless.

"Expectations may be getting a little high but I don't want to be on the naysaying side of combined monetary and fiscal stimulus," Bollinger continued, professing to be nervous about stocks, "but not really fearful."

That nervousness was manifested in Bollinger's decision late this week to sell

Freddie Mac

(FRE)

. Given widespread optimism about the government-sponsored enterprise (GSE), that was also evidence of contrarian investing.

Technically speaking, Freddie Mac made a "classic triple top" this week when it failed to sustain a move above $68, and each attempt occurred on declining volume, Bollinger said.

Additionally, Freddie is "not going to do as well as everybody expects" given his expectations for a rising interest rate environment, which will curtail mortgage refinancing activity. Bollinger forecast that short-term rates will continue to decline modestly, but that long- and intermediate-term rates will rise, leading to a continued steepening of the yield curve (another reason he's not willing to bet against the recovery scenario).

Freddie, and fellow GSEs

Fannie Mae

(FNM)

and

Sallie Mae

(SLM) - Get Report

, will not do poorly, but "less well than investors think," he surmised.

Just a Game

John Roque, senior analyst at

Arnhold and S. Bleichroeder

(and

RealMoney.com

contributor), also addressed the sentiment issue in an interview Thursday afternoon.

The market's penchant for shaking off bad news is historically a good sign, "but everybody is way too cute about the whole game," Roque said. "A stock misses, you buy it and

conversely sell the good news. If it gaps down, buy. If it gaps up, sell. Everybody knows

that and a plethora of people are playing from the trading perspective."

There's nothing wrong with trading

per se

. But the heightened focus on minute-by-minute activity means sentiment becomes extremely fragile, as was evident Friday.

"I think there's no sentiment here -- other than the fact most people believe the second half is going to be better than the first," he said. "But it won't matter what happens because people buying

or selling today might not be next week. Conviction levels aren't high."

Even if fund managers don't believe in a company's fundamentals, many will be buying if the stock is going up, Roque explained. Conversely, they'll be selling if a stock is heading down even if they like the fundamentals.

"I think this is the way it's going to be because at the end of the day

fund managers have got to perform," he said.

In other words, it's going to be a largely trendless market because many participants are simply following trends.

Ironic, isn't it?

Brass Tacks

Like Bollinger, Roque also expressed optimism about small-cap stocks over large. In various reports this week Roque recommended a host of names, including:

Accredo Health

(ACDO)

,

Borland Software

(BORL)

,

Cumulus Media

(CMLS) - Get Report

,

Dial

(DL) - Get Report

,

Forest Oil

(FST)

,

Lincare Holdings

(LNCR)

,

Sylvan Learning

(SLVN)

and

Vintage Petroleum

(VPI)

.

Simultaneously, he expressed skepticism about large-caps

Merrill Lynch

(MER)

and

Anheuser-Bush

(BUD) - Get Report

.

As always, we'll check back periodically to see how these picks fare. And, as always, we encourage readers to use picks mentioned in this column as a

starting point

for their own research, not an endgame.

Speaking of endgames ... have a nice weekend.

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task. TheStreet.com has a revenue-sharing relationship with Amazon.com under which it receives a portion of the revenue from Amazon purchases by customers directed there from TheStreet.com.

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