Too Much of a Good Thing?

Contrarians warn that all the talk of a 'year-end rally' is reaching overly exuberant levels.
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It's hard to talk to traders or market strategists in recent days without encountering the almost religious belief that a fourth-quarter rally is unfolding and will rescue stocks from their paltry year-to-date performance.

A lot of uncertainty followed the major indices' plunge to five-month lows in October. Until this week, moving back out of the October hole has been a strenuous exercise.

But after Thursday's gains, the

S&P 500

has now rallied 3.6% to 1219 from its Oct. 20 low of 1177, the

Nasdaq Composite

has advanced 6% to 2160 from its Oct. 12 low of 2037, and the

Dow Jones Industrial Average

has risen 3% from its Oct. 21 low of 10,215.

But with the feel-good sentiment abounding, euphoria levels are catching the eyes of contrarian market strategists.

Richard Bernstein, a Merrill Lynch strategist who relies on long-term contrarian indicators, says his Sell-Side Indicator, which is based on a survey of Wall Street strategists recommended asset allocations, flashed a formal sell signal on Oct. 31 for the first time since late 2003.

This indicator has historically been a reliable indicator, the strategist says. "In other words, it has historically been a bullish signal when Wall Street was extremely bearish and vice versa."

Bernstein recognizes that the indicator is not always spot on -- for instance, it missed the bulk of the 2003 rally. But he notes that this is the first time since 1998 that the indicator turned around quickly enough to jump directly from a neutral to a sell signal.

The strategist says the signal "does not imply a market collapse." Instead, it confirms his expectations that the S&P will not yield more that single-digit returns 12 months out, and it supports his August decision to raise his cash allocation as the

Federal Reserve

continues to lift short-term rates.

Other trend watchers, however, are setting their sights on this year's highs, which were hit in early August for the S&P and the Nasdaq. The S&P hit a high of 1245 on Aug. 3 and the Nasdaq hit a high of 2218 on Aug. 2. The Dow, meanwhile, reached its 2005 high of 10,940 on March 4.

But given the recent whiff of optimism, and its suddenness, not many are betting that these previous highs will be successfully broken.

"In the short term we have a tradeable rally, but it will be really challenging to try and test those prior highs," says Joe Sunderman, market strategist at Schaeffer Investment Research. "There's not enough factors to help us break out of the current trading range. For one, there's still too much optimism out there."

At the current pace, a challenge to this year's highs could be made before the end of November but "after such a quick run, most technicians would say that we've entered an overbought market," Sunderman says.

Based upon the market's performance through Wednesday's close, Morgan Stanley technical analyst Mark Newton already believes the major indices have "advanced to an area that should be a sweet spot for profit-taking opportunities."

Newton also notes that the put/call ratio (option bets that stock prices will fall vs. bets that they will rise) has fallen to 0.49, its lowest reading since mid-July and an indication that bullish sentiment is very high. He expects a pullback from current levels, but Morgan's team isn't sure yet whether this will present a buying opportunity.

Perhaps a good indication of an overly euphoric equities market is when the stock market starts ignoring other areas of the investing universe that compete with stocks to attract capital, such as government bonds.

In that respect, however, market action Thursday showed at least some caution existed in the stock market. Some late-afternoon profit-taking was evident as the yield of the benchmark 10-year Treasury bond touched its annual high at 4.64%. Bonds fell as inflation jitters were revived by

hawkish comments from Fed Chairman Alan Greenspan and stronger-than-expected economic data. But earlier on, equities players chose to focus on news that third-quarter productivity had improved, as did retail sales in October.

The Dow finished up 49.86, or 0.48%, at 10,522.59, off an earlier high of 10,561.16.

Merck

(MRK) - Get Report

lifted the blue-chip average after a jury found the pharmaceutical giant wasn't liable for a plaintiff's heart attack, allegedly caused by Merck's Vioxx.

The S&P 500 rose 5.18 points, or 0.43%, to 1219.81 vs. its intraday best of 1,224.70. The Nasdaq gained 15.91 points, or 0.7%, to 2160.22 but off its earlier high of 2,169.98. Semiconductor issues were leading the gains, led by the likes of

Micron Technology

(MU) - Get Report

.

Recent news that American consumers are still spending after the hurricanes and amid higher energy prices is indeed a "bullish signal that should give

the market a shot in the arm," says Schaeffer's Sunderman. But "if yields continue to push higher, you're going to have competition between the equity and bond markets. And given that the equity market has done very little this year, investors might start veering towards bonds."

In other words, perhaps what's keeping the stock market in ranges is that whenever there's cause for euphoria -- a solid economy and resilient consumers -- that more ammunition for a hawkish Fed. Of late, the bond market is catching on to the game.

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

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