Sentiment in the stock market is the most bullish in years, while the credit markets are showing signs of stress. Sound familiar?

It should. Back in July, the stock market made new highs even as investors sorted through the collapse of two

Bear Stearns


hedge funds. That shock wave sent risk premiums in junk bonds and loans rising, and KO'd some financing deals for leveraged buyouts -- but didn't touch stocks until later, when a full-blown liquidity crisis emerged. Then shares dropped 10% until the selling eased in mid-August.

Now, on the 20th anniversary of Black Monday -- when the

Dow Jones Industrial Average

fell 508 points, or 22.6% -- investors are back to extreme optimism, with some signs that stocks are overextended. The warning signs of a fourth quarter credit crunch are growing, and the backstops, balance sheet cushions, and rescue artists may be less available this time around.

"The market's been Google-ized," says Randy Diamond, trader at Miller Tabak, comparing broad market optimism to the high expectations for strong earnings from Internet search company


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. Google didn't disappoint after the closing bell Thursday, reporting earnings that beat Wall Street's estimates. Other tech companies like


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have also weighed in with better-than-expected earnings this season.

The optimism has sent the number of bulls in the stock market up for an eighth straight week, reaching 62%, the most exuberance since December 2004, according to Investors Intelligence. The proportion of investors identifying themselves as bears fell to 19.6%, bringing the spread between bulls and bears over 40 points. These are extreme sentiment levels associated with market tops, according to the service. MarketVane's measure of bullish consensus in the Nasdaq Composite futures is at 83%, an all-time high.

Meanwhile, the credit markets are coming under pressure, revealing renewed anxieties about the ability of the financial system and the economy to hold up after credit products were repriced lower in August.

A flight-to-quality trade has buoyed Treasury bonds in recent days, as risk premiums of high-yield bond and leveraged loans increased. The one-month Treasury bill rate is down 44 basis points to 3.68%, marking its largest drop since a67-basis point drop on Aug. 20, according to Miller Tabak. The 10-year Treasury bond is yielding 4.5%, down from last Friday's 4.7% yield.

"Sentiment and credit market conditions suggest the market is very extended," says Alex Grace, trader and hedge fund consultant. "There is limited upside." Grace recommends that clients use caution and take a market-neutral stance now.

And, while investors cheer the sale of bonds and loans to finance the leveraged buyouts of

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, these deals were just the tip of the iceberg. Banks still have more than $200 billion worth of financing to work through. That's on top of mortgage-backed security-oriented writedowns and problems with off-balance-sheet investment funds that forced several banks to create a bailout fund to prevent further damage.

Signs of stress in the financial sector are there for all to see.


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Washington Mutual

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Bank of America

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reported disappointing earnings this week. Fed officials and Treasury Secretary Henry Paulson have stopped claiming the damage from the collapse of the housing bubble is contained.

"Every day, we're doing little things to move forward," said Jonathan Calder, co-head of loan and high yield sales for U.S. and Europe at Citigroup. Calder made his remarks Wednesday at the Loan Syndication and Trading Association conference in New York, where he spoke of efforts to restore confidence in fixed-income markets that remain stalled. Keeping confidence afloat and deals moving out the door is essential, he said, because "banks don't have much balance sheet right now."

Part of that effort includes trying to lure hedge funds to the leveraged loan market to buy the deals on the backed-up calendar. For weeks, hedge funds created to take advantage of opportunities to buy so-called distressed assets were heralded as the saviors for this market.

But the saviors have largely stayed away as the "opportunities in the market are not what they thought they would be," said Bob Wagner, head of global markets at Silver Point Capital. He says these investors are looking for loans priced at 92 cents on the dollar or lower -- not 96 or higher, where deals have come.

That leaves hedge funds like Silver Point, which aren't focused on distress, to pick up the slack. This group, he claims, could bring about $50 billion worth of buying power to the table. But he adds that buying power needs to be leveraged up to give the investment high-enough yield.

In the current environment, "it is hard to find leverage," says Wagner. Banks have reined in lending to hedge funds to protect the little room left on their balance sheets. Wagner adds that these desperately needed investors are likely to abandon the loan market quickly unless they get prime brokerage support.

No balance sheet, no dice.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click


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