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Stock Market: Is It Over Sold?

Strategas Research analysts today say the stock market looks oversold and could be setting up for a short-term rally.

In a note today, the firm looked at the record level of short interest and other factors. Last week, the percent of short interest on the NYSE was at 4.2 percent, an all time high.

"We typically look at short interest as a contrarian indicator. We said the record level of short interest that we're seeing now at one time could be explained by the amount of hedge funds, but since hedge fund assets recently plateaued and made a top, we just think this is a very bearish sentiment which is a contrarian sign," said Chris Verrone, an analyst at Strategas.

Verrone says that Strategas Research's own proprietary market sentiment index is now at levels last seen in April, and it is pointing to an oversold condition. "It's at a level right now that we traditionally associate with a buy signal. It's one of the reasons we see a rally in the next two to three months," Verrone said.

"For the most part, the economic data has been bad, not awful. We think in the next three months there could be room to run, but we remain pretty bearish in the next 12 to 18 months because we think we pay for a lot of the stimulus in '09, and we think we set up for a more traditional cyclical slow down the second half of '09," he said.

Verrone says you can't put an exact time frame on when the market could make a move but it looks like it's getting ready. On the horizon is the end of the quarter Monday, and then earnings season gets underway the following week.

Strategas says it's not surprising that the most negative sentiment is among the market's highest beta sectors - financials and consumer discretionary. "For those with long-term time horizons, it's hard not to be bearish on these two sectors. Still, the current short interest data suggest that the trade is presently over-owned," the firm says in its note.

Check out those financials today. They are showing some signs of life after days of selling. the S&P financial sector was up more than 2 percent at midday. Stocks like Bank of America, American Express, Goldman Sachs,JP Morgan and Citigroupare all up two percent or more. Lehman is more than 5 percent higher. Watch it though. One trader cautions we're seeing some end of quarter trades, and sellers are looking for any sign of strength to make their move.

Questions? Comments? marketinsider@cnbc.com

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