Absolute Return Portfolio Management LLC

Since early February's market lows, investor sentiment has rapidly cycled from fear to excessive optimism. Historically, such rapid conversion of fear to greed suggests an underlying uncertainty over economic conditions where market trends create extremes in psychology.

The Equity Put/Call ratio, which measures speculative sentiment among the unsophisticated public, recently reached extremes not seen since the October 2007 top. Similarly, the ISE Equity Put/Call Ratio, which uses only opening transactions and is considered a superior calculation of sentiment, is also showing the highest levels of optimism since October 2007. Its readings are also similar to those the accompanied the more recent market peak in mid-January of this year.

Weekly sentiment polls are also approaching market peak levels but are not yet at extremes. This could suggest that the topping process is not complete.

As I've written many times before, it is the combination of weak market internals coupled with extreme sentiment that needs to be heeded. For the first time since this rally began in early February, I am seeing signs of deteriorating market internals which is suggestive of a market top.

For example, the 52 Week New Highs / New Lows data set indicated that the peak number of New Highs occurred over two weeks ago. Today, even though index prices are at new highs, the number of 52 Week New Highs has dropped by 50% from 400 to 200. In a healthy market advance the New Highs should expand with higher prices. Accordingly, the New Highs today should be greater than 400 if the advance was healthy.

Similarly, the McClellan Oscillator is in its weakest condition since the mid-January peak which preceded a nearly 10% decline.

In summary, excessive investor sentiment coupled with deteriorating market internals strongly suggests that the market, at a minimum, will consolidate its gains since February. Just as likely, the topping process may be marking the top of the trading range and downside risk approaching 10%+.

The US Dollar appears to be in a solid intermediate-term uptrend which favors domestic equity investments.

It will be interesting to see if this recent upswing will persist in the face of the anticipated equity market weakness. Generally, all risk assets move in tandem; previously equity market declines were paralleled in the commodity markets.

It is possible that the excessive liquidity in the economy could be creating inflationary pressures that would be bad for both equities and bonds. A situation which does tie in with my concern that the equity market could be headed for its February lows...

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