By Robert W. Colby, Senior Analyst

4th biggest shakeout in 4 years
Credit woes: overblown or the tip of the iceberg?

All stock market oscillators read “oversold”.

U.S. T. Bond prices made a new 9-week price high on a flight to safety.

Large Caps broke out to a new 21-month high relative to Small Caps.

Industrial stock sector relative strength made another new high.

Utility stock sector relative strength made a new 5-month low.

Financial stock sector made a new 10-month closing price low.

The outlook ahead appears foggy, allowing fear to substitute for fact. Suddenly, sub-prime borrowers of all kinds are finding it hard to find investors willing to lend money on favorable terms. Investors are now demanding 3.9 percentage points more yield on junk credits over the safest 10-year Treasury note yield. This low-quality premium is nearly double the 2.1 percentage points premium just 2 months ago.

Some traders now fear that this situation may get worse before it gets better. No one has a good handle on where all this is going, and in the absence of hard data, emotion takes the place of reasoned analysis.

Technically, present conditions appear less foggy. We can precisely measure the actual data produced by the market itself. This data has proved to be useful in the past–far from perfect but useful nevertheless. (Of course, past performance offers no assurance of future performance.)

The popular S&P 500 ETF (SPY) low on Friday 7/27/07 was 145.05. The one-year uptrend line from the low of 7/17/16 was at 145.08 and rising. It could be possible that the one-year uptrend line provided technical support on Friday.

The SPY halted its decline on Friday just above its still rising 200-day simple moving average, which closed at 144.87. Longer-term moving averages are also in rising trends.

The SPY is still up from the end of Q1 2007 and is higher than it has been anytime from the end of year 2000 through 2006.

This is an above-average size shakeout measured against the history over the past 4 years. At Friday’s close at 145.11, the SPY is down 6.42% from its closing high of 155.07 set on 7/19/07. This decline is greater than the 5.95% decline in February-March 2007, but less than the 7.59% drop in May-June 2006.

Since the low on 3/11/03, there has been no shakeout in excess of 9%, 1 shakeout in excess of 8%, 3 shakeouts in excess of 7%, and this is the 4th shakeout in excess of 6%.

There have been 10 declines in excess of 5%, 14 declines in excess of 4%, 18 declines in excess of 3%, and a total of 32 declines in excess of 2%.

The SPY violated obvious technical support at 146.42, which was the high on 2/22/07, thereby electing some stops.

The VIX “Fear Index” now indicates the greatest level of fear in more than 4 years, since 4/11/03. On Friday 7/27/07, VIX rose to 24.17, surpassing its extreme height of fear of 23.81 recorded on 6/13/06, the day of the SPY closing price low terminating a 7.59% downside price shakeout. VIX is a market estimate of expected constant 30-day volatility, calculated by weighting S&P 500 Index CBOE option bid/ask quotes spanning a wide range of strike prices for the two nearest expiration dates.

The CBOE Equity Volume and Put/Call Ratio ( rose to 0.85 on 7/26/07, which is more than 2 standard deviations above the one-year mean of 0.64. This means that the Put/Call Ratio hit a level not attained as much as 2.5% of the time. This Put/Call current reading of 0.85 has not been seen since the shakeout in March 2007. The past 12 months’ Put/Call range is 0.45 to 0.98.

Huge downside volume indicates panic, selling climax conditions.

The SPY is now oversold according to all short-term oscillators.

Still, it might be safer to wait until downside momentum stalls out before adding to long positions. Also, the first bottom is often revisited or tested after a period of days or weeks.

Spotlight on event stocks: Here is a stock screen I designed to pick out potential “event” stocks, both Bullish and Bearish. Sometimes, stocks with large changes in price and volume are revealed to be deal stocks, sooner or later, or are the subject of some other extraordinary events, positive or negative.

Bullish Stocks: Rising Price and Rising Volume
% Price Change, Symbol, Name

5.20% , GPS , GAP
1.82% , DJ , DOW JONES
1.82% , MYY , Short 100% MidCap 400, MYY
4.64% , SDS , Short 200% S&P 500 PS, SDS
0.91% , CDWC , CDW Corporation
1.25% , BLL , BALL
0.29% , TLT , Bond, 20+ Years Treasury, TLT
0.96% , DBC , Commodity Tracking, DBC
0.92% , DISCA , Discovery Holding Co.
0.17% , AZO , AUTOZONE
0.22% , EXPD , Expeditors International WA
0.17% , TLAB , TELLABS

Bearish Stocks: Falling Price and Rising Volume
% Price Change, Symbol, Name

-15.72% , QLGC , QLOGIC
-2.63% , PHW , Hardware & Electronics, PHW
-4.58% , PWV , Value LargeCap Dynamic PS, PWV
-4.19% , PWER , POWER ONE
-1.52% , IEV , Europe 350 S&P Index, IEV
-2.88% , PSJ , Software, PSJ
-3.66% , PJP , Pharmaceuticals, PJP
-1.15% , XSD , Semiconductor SPDR, XSD
-1.98% , RZV , Value SmallCap S&P 600, RZV
-2.31% , DSV , Value Small Cap DJ, DSV
-1.95% , PWP , Value MidCap Dynamic PS, PWP
-2.61% , IYH , Healthcare DJ, IYH
-1.81% , ELV , Value Large Cap DJ, ELV
-4.67% , DTE , DTE ENERGY
-1.67% , EWU , United Kingdom Index, EWU
-1.43% , EFV , Value EAFE MSCI, EFV
-5.03% , IR , INGER RAND
-2.12% , BHH , Internet B2B H, BHH
-1.73% , PFM , Dividend Achievers PS, PFM
-2.33% , PBE , Biotech & Genome, PBE
-1.56% , NYC , LargeCap Blend NYSE Composite iS, NYC
-4.16% , VRSN , VeriSign Inc
-1.80% , PTE , Telecommunications & Wireless, PTE
-0.74% , EWD , Sweden Index, EWD
-4.56% , ITT , ITT INDS
-1.34% , S , SPRINT NEXTEL
-3.44% , EWA , Australia Index, EWA
-1.22% , IYZ , Telecom DJ US, IYZ
-4.16% , SSCC , Smurfit-Stone Container Corporation
-2.80% , FNM , FANNIE MAE
-1.67% , VPL , Pacific VIPERs, VPL
-2.92% , PIC , Insurance, PIC
-1.11% , IYF , Financial DJ US, IYF
-1.53% , EWC , Canada Index, EWC
-1.51% , JKE , Growth LargeCap iS M, JKE

Sectors: among the 9 major U.S. sectors, all 9 fell.
Major Sectors Ranked for the Day
% Price Change, Sector

-1.34% Consumer Staples
-1.56% Financial
-1.57% Consumer Discretionary
-1.86% Industrial
-2.14% Technology
-2.28% Materials
-2.38% Health Care
-2.89% Energy
-2.97% Utilities

Looking beyond the daily fluctuation to the major trends (listed in order of relative strength):

Energy (XLE) Bullish. Price made a new high on 7/20/07 and relative strength made a new high on 7/23/07. XLE has been relatively strong compared to the S&P since 3/12/03. Overweight.

Materials (XLB) Bullish. Price made a new high on 7/19/07 and relative strength made a new high on 7/18/07. XLB has been relatively strong compared to the S&P since 9/27/00. Overweight.

Industrial (XLI) Bullish. Price made a new high on 7/19/07 and relative strength made a new high on 7/27/07. XLI has been relatively strong compared to the S&P since 8/9/06. Overweight.

Technology (XLK) Bullish. Price made a new 6-year high on 7/19/07 and relative strength made a new 19-month high on 7/26/07. XLK has been relatively strong compared to the S&P since its low on 7/24/06.

Utilities (XLU) Bearish. XLU has been relatively weak compared to the S&P since 9/20/01. Underweight.

Consumer Discretionary (XLY) Bearish. Price made a new 4-month low on 7/26/07. XLY made a new 10-month relative strength low on 7/26/07 and has been relatively weak compared to the S&P since 1/5/05. Underweight.

Consumer Staples (XLP) Bearish. Relative strength made a new 7-year low on 6/19/07. XLP has been relatively weak compared to the S&P since 10/9/02. Underweight.

Health Care (XLV) Bearish. XLV made a new 5-year relative strength low on 7/19/07 and has been relatively weak compared to the S&P since 10/9/02. Underweight.

Financial (XLF) Bearish. XLF made a new 10-month closing price low on 7/26/07and a new 5-year relative strength low on 7/23/07. Underweight.

Foreign stocks in a correction since 7/12/07. The long-term trend is still Bullish. EFA (the EAFE, international developed country stock markets, ex the U.S. and Canada) has outperformed the S&P 500 since 3/19/03.

NASDAQ outperformed since 5/17/07. Relative strength made a new 8-month high on 7/26/07.

Growth has been beating Value since 5/16/07. Longer term, the major trend of Growth/Value, mostly Bearish for seven years, could be turning.

Large Caps broke out to a new 21-month high relative to Small Caps. Large Caps beat Small Caps since 4/19/06, and that trend in is motion.

Crude Oil rose to a new 10-month closing price high. Longer term, the U.S. OIL FUND ETF (AMEX: USO) remains in its uptrend since its shakeout low at 42.56 on 1/18/07.

Energy stocks fell steeply, underperforming both USO and S&P. Long term, since 3/12/03, the stocks in the Energy Select Sector SPDR ETF (XLE) have significantly outperformed crude oil as a commodity, as well as the S&P 500. So, the Relative Strength major trend is Bullish for the energy stocks.

Gold surrendered July gains. StreetTRACKS Gold Trust ETF (NYSE: GLD) has been in a choppy trading range since 5/12/06.

Silver underperformed Gold since 6/5/07. Longer term, iShares Silver Trust (AMEX: SLV) broke down to a new 6-month low on 6/26/07 and underperformed GLD since 12/7/06. So, the main trend is relatively Bearish.

The Gold Miners Index (XAU) underperformed Gold since 7/19/07. XAU also underperformed Gold since 1/31/06.

Deflating: inflation expectations moved sharply lower. The ratio of the price of bond TIPS to 10-year U.S. Treasury Notes has been falling since 6/22/07, indicating declining inflation expectations.

U.S. Treasury Bond prices made a new 9-week price high on 7/27/07 on a flight to safety. Money is shifting from risk to safety. The short-term bond price trend has been Bullish since the price low on 6/12/07. But since the peak at 97.66 on 6/16/03, the long-term trend appears Bearish for iShares Lehman 20+ Year U.S. Treasury Bond ETF (AMEX: TLT).

U.S. dollar: sharp oversold counter trend bounce since 7/24/07 low. Longer term, dollar fell to a new 15-year price low on 7/24/07. The dollar has been falling most of the time since its peak at 121.29 on 7/5/01.

Daily Rankings of Major Global Markets, Ranked from Strongest to Weakest of the Day:

0.65% US Dollar Index
0.02% Spain
-0.01% Japanese Yen
-0.11% 30Y T-Bond
-0.29% Mexico
-0.35% Malaysia
-0.43% Swiss Franc
-0.54% Broker Dealers
-0.60% Banks
-0.61% Brazil
-0.63% Switzerland
-0.73% Euro Index
-0.74% Sweden
-0.74% Canadian Dollar
-0.97% Japan
-1.12% Hospitals
-1.12% Hong Kong
-1.14% British Pound
-1.15% France
-1.19% Singapore
-1.23% Retailers
-1.25% Italy
-1.31% Dow Transports
-1.31% S&P Mid Caps
-1.34% Consumer Staples
-1.43% Nasdaq Composite
-1.50% Dow Composite
-1.51% NYSE Composite
-1.51% S&P Small Caps
-1.52% Wilshire 5000
-1.53% Nasdaq 100
-1.53% Canada
-1.54% Dow Industrial
-1.54% Russell 1000
-1.54% Internet
-1.55% S&P 100
-1.55% Value Line
-1.56% Russell 3000
-1.56% Financial
-1.57% Consumer Discretionary
-1.58% Computer Tech
-1.60% S&P 500
-1.65% Biotechs
-1.66% Gold Mining
-1.67% United Kingdom
-1.68% DOT
-1.70% Dow Utilities
-1.72% Russell 2000
-1.72% Belgium
-1.76% Network
-1.78% Austria
-1.79% Airlines
-1.80% Commodity Related
-1.80% Natural Gas
-1.86% Industrial
-1.91% South Korea
-1.93% Health Care
-1.99% Netherlands
-2.01% Semiconductors
-2.05% AMEX Composite
-2.12% Health Care Products
-2.14% Technology
-2.15% Insurance
-2.17% Drugs
-2.24% Hardware
-2.27% Disk Drives
-2.28% Materials
-2.32% Oil Services
-2.36% Chemicals
-2.38% Health Care
-2.38% Australian Dollar
-2.43% Taiwan
-2.46% Oil
-2.64% Paper
-2.89% Energy
-2.91% Germany
-2.92% REITs
-2.97% Utilities
-3.44% Australia

To sum up the current position of the U.S. stock market:

Longer term, the U.S. stock market has shown impressive Bullish resilience since the major low on 10/10/02, more than four years ago. Stock prices have been buoyed by abundant global liquidly (following years of fiscal stimulation, rapid money supply growth, and rising corporate profits), M&A, and earnings comparisons above expectations.

Liquidity driven merger and acquisitions news has been helping to keep the old Bull alive. Both U.S. and foreign corporations hold excess cash after several years of rising profits, and so M&A speculation as well as leveraged buyouts and corporate stock buybacks have provided substantial Bullish stimulus to stock prices. In 2007, mergers and acquisitions are running about 60% ahead of 2006’s record pace, driven by rising stock prices and private-equity funds that raised more than $250 billion for takeovers since the start of 2006. Takeovers are on track to surpass 2006’s all-time high of $3.49 trillion, according to data compiled by Bloomberg.

Conservative earnings estimates also have been useful in keeping the old Bull alive. First quarter 2007 corporate earnings reflected a significant growth slowdown. Nevertheless, earnings were ahead of expectations, which had been lowered to very conservative levels in advance of actual reporting. Managements and Wall Street have learned that investors hate disappointments, so they simply don’t give them any–unless absolutely necessary.

Investors might perceive anything that threatens to end abundant global liquidly, M&A, leveraged buyouts, corporate stock buybacks, and the net balance of positive earnings surprises as threats to the popular Bullish scenario.

Stocks generally are fully valued to over priced by long-term historical standards. Although that alone does not mean that stocks cannot continue to trend higher (and indeed they have) nevertheless, it is good to remember that “no tree grows to the sky.” The cyclical nature of stock prices never really changes, although the turning points are not always easy to predict.