SENTIMENT NUMBERS

Averages completed a second consecutive positive week on Friday to achieve new 52-week highs. The advance was convincing enough to noticeably shift the advisors.

The bulls moved up to 49.5% after dipping to 47.2% the previous week. They have still not equaled their mid-August peak of 51.6% despite the higher levels for the markets. The next few weeks could see more earnings reports exceeding forecasts and that could drive the markets still higher. It may prove timely if increased optimism accompanies any additional market rally. We associate bulls at 55%-60% with market tops, so watch to see if those levels are achieved. They were last shown at the end of 2007.

The bears declined to 23.1% after reaching an eleven-week high at 26.4% a week ago. The bears are still above the 19.8% reading from mid-August. A reading below 20% typically occurs near a top. The mid-August reading was the fewest bears since the all-time market high of October 2007 when their number was 19.6%.

Advisors classified as correction rose to 27.4% from 26.4%. This group is mostly bullish but they expect an intervening market retreat before the rally begins. They look to buy on dips. Advisors often shift from bearish to correction before they are ready to make a bullish commitment. The correction range for the last five weeks has been 28.9% to 25.8%.

The advisors show a major shift from the bear markets lows in October and November 2008 and March 2009. Those bottoms had the bulls at 22.4%, 23.1% and 26.4% respectively while the bears were 54.4%, 49.5%, and 47.2%. Note that the sentiment extreme occurred ahead of the final bottom.

The difference between the bulls and bears expanded to +26.4% after narrowing to +20.8% last week. That latter level had almost fallen out of the bearish zone. Sentiment readings remain bearish.

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INTERMARKET ANALYSIS.... WHY IGNORE IT?

BREAKDOWN IN BOND YIELD MAY BE BAD FOR STOCKS ... One of the catalysts behind Thursdays heavy stock selling was the breakdown in Treasury bond yields. The 10-Year T-note yield fell below its July low to the lowest level in more than four months. Bond yields are an indicator of confidence in the economy. When investors are optimistic, they buy stocks and sell Treasuries. That pushes bond yields higher. When they're more pessimistic, they sell stocks and buy Treasuries. That pushes yields lower. So the direction of Treasury bond yields has some bearing on the direction of stocks. That's been especially true over the last two years. The weekly bars in Chart 1 compare the trend of the 10 Year Treasury Note Yield (TNX) to the S&P 500 (green line). At least two things are apparent. One is that bond yields and stocks have usually trended in the same direction. The second is that bond yields have tended to change direction first. Bond yields started dropping during the summer of 2007 several months before stocks peaked. Bond yields started bouncing at the start of 2008 and anticipated a stock rebound that spring. After falling together during the second half of last year, bond yields turned up several months before stocks. Chart 2 shows bond yields turning up in January of this year two months before stocks' March bottom. Bond yields peaked in June, however, and have been weakening since then while stock prices have risen. That "negative intermarket divergence" grew more serious with yesterday's breakdown in yields.

COMPARING TREASURIES TO JUNK ... One of our readers asked whether Treasury prices or junk bonds gave better warnings. I think it's better to use both of them together. Investors buy high-yield (junk) bonds when they're more optimistic and Treasuries when they're less so. In fact, both are giving warning signals at the moment. Chart 3 shows the 7-10 Year Treasury Bond ETF (IEF) breaking out to the upside on Thursday on strong volume. Chart 4 shows the Lehman High Bond ETF (JNK) falling on heavy volume. Both of those trends show more investor caution. [Investment grade corporate bonds also fell heavily on strong volume]. If Treasury prices continue to rise, and junk bonds drop, that would be a more serious warning on the economy and stocks. It's also useful to compare the two bond classes. Chart 5 is ratio of JNK to the IEF. Junk bonds underperformed Treasuries during the second half of 2008 (when stocks were falling), but bottomed in March (along with stocks) and has been rising faster than treasuries since then. In other words, investors favor Treasuries when stocks are weak and embrace junk bonds when stocks are rising. Chart 6 gives a closer view of the JNK:IEF ratio. This week's sharp drop in the ratio is an initial warning of investor nervousness. A drop below the September low would be a more serious warning that investors are starting to abandon risker corporate bonds and starting to favor safer Treasuries.

AMZN