The Rally Plays Peek-A-Boo

Bonds sell off and the volatility index remains under 20; the talk is about what happens next.
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The conflicting dynamics of Friday's upside surge and Thursday's downward reversal played out again Monday, but with far less drama. In sum, Monday was a relatively sleepy summer session pockmarked by some intraday swings.

After trading as high as 9303.93 and as low as 9234.50, the

Dow Jones Industrial Average

closed down 0.2% to 9266.51. The

S&P 500

ended off 0.2% to 996.52 vs. its intraday high of 1000.68 and low of 993.59, while the

Nasdaq Composite

rose 0.3% to 1735.40 after trading in a range between 1740.40 and 1726.20.

Revelations of fines levied against

J.P. Morgan

(JPM) - Get Report

and

Citigroup

(C) - Get Report

had little effect on the financial giants, much less broader stock proxies. J.P. Morgan rose 0.1%, while Citigroup gained 0.2%.

Similarly, earnings from

American Express

(AXP) - Get Report

,

Northrop Grumman

(NOC) - Get Report

and

Kellogg's

(K) - Get Report

had mainly company-specific implications.

As has often been the case of late, action in stocks was outshined by movements in Treasuries, where prices swooned amid concerns about pending new supply. The Treasury Department said Monday it expects to borrow $104 billion in the current quarter vs. prior estimates of $76 billion, and a record $126 billion in the final three months of the calendar year.

Ahead of a slew of economic data later this week, the Treasury's announcement helped push the price of the benchmark 10-year note down 31/32 to 94 20/32, its yield rising to 4.30%.

Optimists have suggested the recent rise in bond yields indicates the fixed-income market's bet on faster economic growth. That would augur positively for shares, but the Treasury market may not be forecasting future economic growth as much as responding to rising budget deficits and the increased government borrowing they will spur.

"Chronic budget deficits will ultimately lead to higher interest rates, less investment, lower productivity growth and a slower growth rate in the nation's standard of living," William Dudley, director of U.S. economic research at Goldman Sachs, opined last week. "In this regard, the problem is not the near-term deficits but the fact that large budget deficits are likely to become a chronic feature of the economic landscape."

It's probably a stretch to attribute Monday's stock action to concerns about such macro issues. But the latest selloff in Treasuries may have hampered the ability of equities to build on Friday's rally. In any event, the session did nothing to end the stock market's recent range-bound activity.

Bulls in the Midst

Those looking for some hints of the market's next move might note that biotech shares -- often a good barometer for market players' speculative juices -- were quite strong Monday amid a raft of rumors about possible mergers.

ImClone

(IMCL)

jumped 9.6% and

Celgene

(CELG) - Get Report

by over 7% on rumors they are potential takeover targets, helping the Amex Biotech Index rise 2.2%.

Meanwhile,

Oxigene

(OXGN)

soared nearly 60% in very heavy volume after the Food & Drug Administration granted so-called

orphan drug status to the firm's anaplastic thyroid cancer drug.

To some, such movements speak to a still-high level of optimism and love of risk among market participants.

"There is ample evidence that the upside has been powered by another leg of manic activity, momentum players and all," wrote Alan Newman, editor of Longboat Global Advisors'

Crosscurrents.

Newman fretted he is "becoming increasingly worried about odds growing for a stock price collapse if the rally forces another round of short-covering and momentum hijinks into August."

Many bears expect another rally in the coming weeks that will fail and pave the way for some sharp downside action in late August and/or September, historically the market's worst month. In a technically perfect world, any such rally would fail at around the S&P's recent high of 1015. However, the market has a way of dashing expectations, so it's unlikely that scenario will unfold so neatly.

That aside, Newman's comment about sentiment being a "one-way street" speaks to another hot topic of conversation. Exhibit A in the debate about sentiment is the CBOE Market Volatility Index, which fell below 20 late last week for the first time since March 2002. (The VIX dipped a fraction to 19.93 on Monday.)

Even the oft-bullish Don Hays of Hays Advisory Group expressed concern about the sub-20 VIX on Friday, writing: "In every case the VIX moves above 40," as occurred intraday on March 12, "the resulting low in the next few days will be the low from which no serious intermediate-term risk will occur until

the VIX drops under 20."

Hays said this "40-20 rule" has "never failed to work in its relatively short 18-year history," and recommended short-term traders employ a bit of caution in the coming weeks.

True to (recent) form, however, Hays tried to put a bullish spin on things, suggesting this sub-20 VIX reading might be different. (As an aside, several readers believe the VIX is merely returning to its historic average in the mid-to-high teens and that 20 will prove to be a new ceiling for the index. Mean-reversion may occur, but I don't think it's going to be so quick and easy as this recent decline implies.)

On Monday, the strategist took umbrage with the notion that there's too much bullishness, citing "huge open interest" in the Nasdaq 100 August puts and more than $4 trillion sitting in "low-yielding" savings accounts and money market funds. "Too bullish -- you've got to be kidding."

Old Gurus Never Die

But seriously ... Hays, once a favorite of this column, damaged his credibility with readers by being steadfastly bullish in 2001 and 2002. Not surprising, he has become even more emboldened about the bullish view in recent months.

In a separate but related note, Tom Galvin of U.S. Trust is scheduled to be a featured guest on

CNBC's

"Squawk Box" Tuesday morning.

For those with short memories, Galvin was the strategist at Donaldson Lufkin & Jenrette and then Credit Suisse First Boston after it bought DLJ. This column dubbed him

the king in 2000 and closely followed his

exploits before he was deposed late last year, presumably for being steadfastly bullish during the downturn.

Galvin's re-emergence only provides more fodder for those who believe we're now going through a mini version of the 1990s speculative mania.

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.