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Traders Gearing Up For Market Sell-Off

Stocks could drift on low volume in the final weeks of summer, but traders increasingly believe a pull back is brewing in the not too distant future.

NYSE Traders
Oliver Quilla for CNBC.com
NYSE Traders

Even short interest, a powerful market driver, is waning. Goldman Sachs says the short interest ratio for the S&P 500, at 1.8 days, is at its lowest level in a decade.

Now that the earnings reporting season has wound down, traders are increasingly looking ahead to the possibility of a sell off that could shave some of the 40 plus percent gains made since early March.

In the week ahead, there are a handful of major earnings, like Home Depot, Hewlett Packard and Deere, and some important data on inflation, housing and manufacturing. Investors will also be watching for guidance on the economy from the Fed's annual huddle in Jackson Hole, Wyo., where Fed Chairman Ben Bernanke gives the keynote address Friday.

"It's going to be all about the consumer next week, and I don't know if there's going to be enough players around to care. As far as this week, the market really just came off a rocket ship of a ride after the last two to three weeks of earnings season. It didn't really find the catalyst to catapult it further," said Art Hogan, managing director at Jefferies.

Hogan said he sees a combination of factors that could affect buying interest. For one, he said some of the institutions that were waiting to put money into stocks may have already done so or are holding back in anticipation of a sell off. Other factors are the big drop off in short interest that eliminates some buyers, and a trend on the part of corporate insiders to sell, rather than buy.

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"Add those things together, and it takes away a core level of support we used to have. If short interest decreases significantly, which it has over the last three weeks, then that buyer is nowhere to be found," Hogan said.

Goldman Sachs strategists, in a note, said the most shorted stocks outperformed the least shorted stocks by 9 percentage points since mid-July, indicative of the short covering trend traders say has helped drive the rally. The consumer discretionary sector, among the best performers, is the most shorted sector.

Stocks ended the past week on a down note, the first weekly loss in five weeks. The Dow was down 0.5 percent at 9321, while the S&P 500 also lost a half percent to 1004. Nasdaq fell 0.7 percent to 1985, still 56 percent above its March 9 low. In the past week, consumer discretionary stocks were the worst performers, down 2.6 percent, followed by industrials, down 2 percent and materials, down 1.7 percent. The best performers were the defensive plays, health care, up 0.6 percent and utilities, up 0.3 percent.

Deutsche Bank's Chief U.S. Equities Strategist Binky Chadha said he had been expecting the market to pull back after the earnings period. "It's simply because I think most investors remain skeptical despite much better than expected results. They don't see those as sustainable or durable. I tend to disagree with that assessment in terms of what we got," he said.

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Chadha said a positive was the fact that the second quarter was the first quarter where sales increased sequentially since second quarter, 2008. For the S&P 500 companies, sales were up 4.8 percent quarter over quarter. He also said companies still have the ability to generate margin improvement.

Traders have been debating whether the market will be able to shake off selling pressure because of the large amount of cash in money markets and in the hands of fund managers. They point to the approach of September, historically the worst time for stocks, as a possible pivot point when the market could correct. Many also say, absent increased negative economic news, the market has succeeded in putting in higher lows and should not have a deep correction.

"I don't think it will be very deep," said Chadha of the pull back which he says could be underway now.

"I think a lot of investors remain defensively positioned, and there are many others who have missed out on the rally and are going to start looking at their annual investment return for the year," he said. Chadha said he expects investors to pull funds from emerging markets, which he believes are overvalued, and that could be a positive for the U.S. market.

Another factor he is watching are rising oil and commodities prices. In the past week, oil was off 4.3 percent to $67.51; gold fell 1.1 percent to $948.70 per troy ounce, and grains were mixed, with soybeans down 6 percent and corn up 0.4 percent. The dollar in the past week lost 0.25 percent against a basket of currencies. It was virtually flat against the euro at $1.4188, but down 2.9 percent against the yen.

"We still remain concerned about the mix of the recovery. Oil prices are still a considerable concern. They've been keeping pace with equities," he said.

"The dollar stopping its fall or just stabilizing, let alone rising, to the extent it checks oil and commodities prices and lets them disassociate from the equities market would significantly improve the idea of sustainable recovery and would be positive for the equities market," he said. Chadha said though he does expect the dollar will eventually reconnect with foreign exchange differentials and trade in its former pattern, instead of in the "risk" trade pattern, where the dollar moves lower as commodities rise.

Chadha said despite disappointing July retail sales data in the past week, the positive surprises in economic data still outpace disappointments, a positive for stocks. However, that trend has been underway for several months and should start to slow down. He does expect third quarter earnings to contain plenty of positive surprises, a trend that should help propel the market later in the year.

Econorama

The week's housing data kicks off Monday with the National Association of Home Builders survey at 1 p.m. Housing starts for July are released Tuesday, and existing home sales are issued Friday. Producer prices inflation data is reported Tuesday.

"For me the biggest issue next week is the housing data," said Stephen Stanley, chief U.S. economist at RBS. "I think we've seen strength in housing starts and I think we may incrementally see another gain in July and that's certainly welcome news, but I'm not going to get as excited about that as I would about gains in home sales."

Stanley said the government program for first time home buyers is stimulating building starts just like the "cash for clunkers" program has stimulated car sales. He expects existing home sales to come in at 5 million, and 615,000 on housing starts.

"I just don't think the whole stimulus is doing a heck of a lot. It's ironic the one program that's working better than expected is this cash for clunkers program. It's very cheap in the scheme of things ..it seems to have a huge amount of traction. Very little else in the way of fiscal stimulus has done anything," he said.

Weekly jobless claims, reported each Thursday, are also another key piece of data this week. "I think the crux of the debate between people who are optimistic and people who are pessimistic is are we going to get job growth. I think firms have cut their payrolls to the bone, and they're not going to a have a choice. They're going to have to pick up more workers. We have payrolls getting back to a positive number by the end of the year," he said, noting he does not hold a consensus view.

The disappointing consumer sentiment and retail sales numbers of the past week have not changed his view on the economy, and Stanley expects positive growth in the third quarter. "There's not a lot of evidence that things are on the cusp of breaking down again," he said. "It feels like everything is progressing as it should. From a very big picture standpoint, we're feeling pretty good about where we are. It's obviously not a very good situation, yet we're certainly progressing. A lot has changed.. where we are today versus February or March, it's been an unbelievable turn around."

Stanley, like many on Wall Street lately, spoke about how at this same time a year ago, the financial system was headed for melt down and financial firms looked ready to fall like dominos.

"It was August of '07 when this whole financial system blew up. That was the beginning of the 'hair on fire' stage of things. Lehman happened in September, but it was really August when Fannie and Freddie went down. I've been kind of holding my breath for a good part of the summer wondering if liquidity conditions would thin. ..whether there was going to be another shoe to drop. I have to say things are very different. It feels much more resilient. We certainly had a few things that could have wobbled," he said. He noted financial markets took problems at CIT in stride.

Other data this week includes the Empire State survey, reported Monday. Leading indicators for July are Thursday, as is the Philadelphia Fed survey.

Earnings Central

Retailers Lowes and Home Depot report Monday and Tuesday, respectively. Hewlett-Packard reports Tuesday, and Deere reports Wednesday. Limited Brands reports Wednesday. On Thursday, Sears Holding, Gap, Intuit, GameStop, Heinz, Hormel, Ross Stores, and Salesforce.com report. J.M. Smucker releases earnings Friday.

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