Published: Tuesday, 13 Oct 2009 | 11:40 AM ET

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Investors have yet to buy in fully to the stock rally even though prices have surged more than 50 percent. But that caution has actually given rise to hopes that the rally still has legs.

"Healthy skepticism" is a phrase used frequently by market pros these days to describe sentiment among investors who are optimistic about Wall Street's performance over the past seven months but cognizant that things could turn around just as quickly.

"Anyone who has half a brain should realize that we're way ahead of where the economy is," says Dave Rovelli, managing director of US equity trading for Canaccord Adams. "There are a lot of good reasons to have skepticism."

Though economists are proclaiming that the recession is over, investors are wary over how quickly recovery will occur and the continued pressure that high unemployment is placing on consumers. Moreover, there continues to be widespread sentiment that the rally can't go on forever—the Standard & Poor's 500 is up more than 60 percent since early March—and a pullback is in the wings.

Jeff Cox
Staff Writer
CNBC.com

Indeed, a spate of sentiment metrics indicates that rather than piling back into the market, investors are entering cautiously:

• BoA Merrill Lynch Global Research said its Sell-Side Indicator still shows that investors are below the normal 60 percent equity allocation in portfolios. "This gives us confidence that there is further room for sentiment and the market to rise before we would consider investors' bullishness to be overdone," the firm said in a note to clients.
• Just 35.1 percent of investors have bullish sentiment, according to the most recent reading from the American Association of Individual Investors. That's below the normal level of just below 39 percent.
• A TD Ameritrade survey showed 45 percent think this is a good time to invest, which the firm said is positive but still reflective of some hesitation.

The upshot, portfolio managers say, is that investors are getting more comfortable with the market but continue to look for safety rather than just an arbitrary technical level to capitalize on a quick rally.

"Healthy skepticism is a good way of saying it," says Nadav Baum, managing director of investments at BPU Investment Management in Pittsburgh. "They're actually looking at market fundamentals. They're getting away from the whole thing that drove (the market slump) which was fear of the abyss."

Panic seems to have left the exchange, with the Chicago Board Options Exchange's Volatility Index

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[VIX  Loading...      ()   ] a shadow of what it was during the depths of the financial crisis.

In turn, the surge, violent though it seems, has been mostly orderly, with few days seeing the gains of more than 2 percent that are more prevalent during bear market rallies.

"Herd mentality doesn't come on the upside, and that's a good thing," Baum says. "It's about companies, it's about earnings and it's also about people that feel like they're going to miss something."

At the same time, short sellers—who took a large share of the blame for the market's 60 percent drop—are more and more leaving the market and abandoning hope of a much-anticipated correction that has yet to take place.

Short interest, a measure of how much investors are betting on the market going lower, dropped 3.4 percent for the last 15 days of September on the New York Stock Exchange. Short interest on the Nasdaq, which is heavily weighted toward technology shares, fell 1.4 percent in the same period.

"People are still too scared to put shorts on," Rovelli says. "What a lot of investors are doing is buying puts. Premiums on puts are higher. But they're willing to pay a higher premium to protect their positions, just because they're so skeptical."

Options activity overall is decreasing.

Average daily volume of options contracts fell about 23 percent in September from the previous year, according to the International Securities Exchange. Options traders continue to be wary of a market correction, but don't want to miss the unrelenting upside.

"It's tempered enthusiasm. There are so many people wary of a pullback in the market," says Andrew Wilkinson, senior strategist at Interactive Brokers. "A market feeds on its own momentum and that momentum is on the upside."

Traders believe the government will step in to prevent any major moves lower, Wilkinson adds.

"I find it hazardous to be one of those people wanting to short the market. That kind of philosophy is entrenched at this moment and that leads people to keep buying the pullback," he says. "I find it tremendously hard to be bearish at the moment."

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