The Shifting Sands of Sentiment

Wednesday's relatively modest moves by stock proxies and absence of major economic data or policy pronouncements gives us a chance to take a step back and look at some various issues of interest, including the smorgasbord of mindsets about this market.

Sentiment and Speculation

Picking up where we left off Monday, the issue of sentiment remains paramount, and the news Wednesday was not good for those long stocks.

Chartcraft.com's Investor Intelligence survey showed bullish sentiment rising to 55.8% vs. 48.3% a week ago. Bearish sentiment fell to 24.4% from 29.2% the prior week. Meanwhile, bullish sentiment among the American Association of Individual Investors' survey of its members fell to 48.6% on May 1 from 63% on April 24. (The next AAII survey is due on Thursday.)

Elsewhere, the CBOE Market Volatility Index and its Nasdaq counterpart continue to hover around recent lows. Although the Nasdaq Composite was Wednesday's relatively weakest major average -- falling 1.1% amid disappointment about Cisco's ( CSCO) outlook -- the VXN slid just 0.4% to 32, ending well off its session high of 33.36.

On a more positive note -- if sentiment is a contrarian indicator -- the CBOE's put/call ratio has crept up from the low 70s late last week to 0.91 Tuesday and 0.92 Wednesday after trading as high as 1.06 intraday. Similarly, the 1-day Arms Index jumped 75% to 1.31 Wednesday, although it's traded in a wide range between 0.62 and 1.33 in the past week.

As discussed here previously, gauging sentiment is tricky because there are so many different ways to measure it. Also, people tend to see what they want to see: i.e. bulls see hordes of naysayers while skeptics decry the wild optimism all around them.

Anecdotally, I've gotten a lot of email lately from readers chastising me for not being bearish enough, something I (frankly) never would have imagined just a few short years ago. Also, most of the market watchers/newsletter writer types I follow -- who aren't dogmatic either way -- remain pretty skeptical about the recent rally, even if grudgingly so.

But money talks and anecdotes walk, to paraphrase Fran Drescher's Bobbi Fleckman character in This Is Spinal Tap.

One notch in the naysayers' belt has been the recent outperformance of speculative and small-cap names.

In April, the lowest-priced 10% components of the S&P 1500 ( S&P 500, MidCap 400 and SmallCap 600) rose an average of 18.9% vs. an advance of 5.7% for the highest-priced 10%, according to Jeff deGraaf, senior technical analyst at Lehman Brothers. That's the highest spread between the two since November 2002.

"Historically, low priced stocks outperforming high priced issues lasts a month or two," deGraaf reported. "The key question to the viability of the market is whether or not other areas of the market will step up as leadership."

Generally, relative strength among lower-priced stocks means "the bad charts are outperforming the good" ones and "in a bull market, the leadership torch is passed to higher-priced names as the rally gains traction," the technician wrote. However, in this instance, lower-priced stocks "are also the best charts in the current market."

For example, he said Sun Microsystems ( SUNW), which slid 3.8% to $3.76 Wednesday, has a "far more attractive chart" than Microsoft ( MSFT), which fell 1.4% to $26.01.

If Mister Softee's chart keeps buyers at bay, the rally could struggle, as Microsoft has far more influence on major averages than Sun Micro and other recently mighty single-digit midgets.

Meanwhile, the speculative juices are embodied, to many, by recent gains in the Philadelphia Stock Exchange Semiconductor Index, Biotech Holders Trust ( BBH), and high-yield bonds. Notably, the SOX dipped 2.4% Wednesday while the BBH shed 1.9% and the S&P Speculative Grade Index -- which mirrors trends in spreads between junk bonds and Treasuries -- rose 11.50 to 1062.60 Tuesday, albeit off its lowest close since June 2002 on Monday.

By the way, deGraaf is one of those aforementioned market watchers who remain dubious. "We believe in playing the rally, but we remain skeptically unconvinced of the new bull market," he wrote. Instead, the technician suspects "that the rally is a test of the upper limits of a trading range that is likely to attract more flies into the trap before it closes."

The Bond Market's Big Question

Although shares were relatively subdued Wednesday, the Treasury market resumed its recent runaway rally. The price of the benchmark 10-year note rose 25/32, its yield tumbling to 3.69%.

The Treasury market's advance, despite the dollar's decline and in the face of onrushing supply of paper while foreign inflows waned for the three months ended February, has proven quite perplexing to many observers. (The dollar stemmed its recent steep decline vs. the euro Wednesday although backtracked further vs. the yen.)

For stock market bulls, the big question is whether the Treasury market is "correct" when it says, in effect, that the equity market is wrong about the economic recovery that stocks have been pricing in.

If fixed-income participants foresaw strong economic growth on the horizon, it's highly unlikely that 10-year yields -- which move in the opposite direction of price -- would be trading below 3.70% and only about 15 basis points above multiyear lows hit in March and October. Faster growth has historically been accompanied by inflationary pressures, which undermine the future value of interest payments and thus are anathema to Treasury investors.

The Federal Open Market Committee's thinly veiled admission Tuesday it is worried about deflation has emboldened fixed-income participants that there's absolutely no cause to worry about inflation at present. Thus, the 10-year's yield has fallen 23 basis points in just the past two days, a huge move in bondland.

As discussed in RealMoney.com's Columnist Conversation, there's a lot of related issues to be considered, including: The role of the Fed, the performance of corporate bonds -- which seems to support the stock market's optimism, as well as whether the Treasury market is really focused on economic issues, or something else altogether. There's also the question of whether the bond market really is "smarter" than the stock market, as many observers contend.

I plan to follow up on this topic soon, as it's crucial to determining the next move by financial markets.

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.

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