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Calling All Contrarian Investors! at Trader’s Narrative




Calling All Contrarian Investors!


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By now I probably sound like a broken record but the evidence for a ricochet off these levels is building up. Let’s run through it quickly:

Today’s close gave us a beautiful “hammer” candlestick formation. Its long tail is trailing right where the S&P 500 index found support back in February of this year:

SPX hammer candlestick patterns May 2010

While not a guarantee, a hammer candlestick is a strong indication of higher prices because it demonstrates that sellers were exhausted and beaten back by the buyers. The important distinction is that while prices were pushed lower during the day, they closed higher, near their intra-day high. As well, prices are right under the 200 day moving average (not shown on above chart) at 1103.59. If prices do move higher sharply, this would be the ideal “bear trap”

Volatility has spiked higher, especially when we look at it relative to its trend to normalize for recent price patterns. Since volatility is a sign of fear, this is a clear contrarian indicator as it cycles back from expansion to contraction again.

Bullish sentiment has sharply dropped off from the extremes seen last month. We aren’t seeing every single gauge register critical levels but then again, that never happens. The important development is that as a consequence of lower prices, investors and traders are not persisting in their optimistic tendencies but instead hightailing it out of dodge.

The decline in optimism is no where more marked than in the Hulbert Nasdaq Newsletter Sentiment index. This is a measure of the portfolio recommendations by a group of newsletters which attempt to time the Nasdaq market. At the end of April, this group of market timers was recommending that their clients have +80% exposure long to the Nasdaq. That raised a lot of eyebrows since it was the second time they had been this bullish - the previous time was during the peak of the tech bubble in the summer of 2000 (when they went as high as +90%).

As the market started to tumble, however, this group quickly abandoned all hope. By May 6th it was down from 80% long to just +42% long. Then a few days later on May 14th they were basically neutral at +3%. Fast forward to today and they are actually recommending to their clients to be short the Nasdaq! The average exposure they are recommending is -45% (or 45% of the portfolio short).

As a contrarian, this is exactly the sort of thing we patiently lie in wait for. There is nary a whiff of complacency or tenacity from the bulls. Had they instead stamped their feet like children, staying long and demanding that the market rise to satisfy their positions or worse, if they had increased their long exposure as they did during the tech bubble, then it would be a very different story altogether.

Breadth is continuing to be extremely negative - the sort of negative extreme where selling is exhausted and buyers step in to pick up bargains. For example, the percentage of S&P 500 constituents trading above their 50 day moving average is still scraping the bottom of the barrel at 7% (a tad higher than the recent low of 6%). And the percentage above their short term, 10 day moving average is just 3%.

The long term breadth measure is showing a weakening of the market and an end to the cyclical bull market. Most S&P 500 stocks has given up their long term trend lines and are trading well below them. Only 38.6% of S&P 500 stocks are above their 150 day moving average and only 50% above their 200 day moving average. As I mentioned before, this points to a shift in the general tone of the market. But even so, the short term opportunity is quite clear and undeniable based on trusted indicators.

I’m hearing rumblings out of Lowry Research which suggest that they are getting ready to shift away from identifying the primary trend as being up. After arriving a bit late to the party, Lowry gave an intermediate buy signal in August 2009. Since then, their bias has been upwards for the market. They believed that we were in the first phase of a cylical bull market or “primary buying phase” marked by momentum and relatively low risk. The next phase is a more sluggish uptrend which has more risk. Their buying and selling indicators are shifting down from their turbo overdrive, reflecting the change in the tone of the market we discussed earlier.

Even if we are entering a more sideways market, it is important to remember that bear market rallies are vicious and intense. As shorts cover their positions from much higher, they are joined by momentum players who pile on and drive prices much higher. And then there are the late comers who think that this is the real deal and buy at the last minute to hold the bag. So at this point, I’m keeping my time horizon short term and relying on basic support, resistance and the indicators mentioned above to find low risk buying opportunities - especially if the S&P 500 is able to close above the hammer candlestick’s top and clear the congestion at ~1080.

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16 Responses to “Calling All Contrarian Investors!”  

  1. 1 paul

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    One problem: the credit market is acting terribly. I cannot imagine much of a rally in stocks with LIBOR going up everyday and CDS spreads on IG and HY blowing out. The rally back in stocks today was merely technical and unsustainable unless we get better support from the credit market.

  2. 2 david

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    Looking at the price pattern, the sell off looks amazingly similar to the one that marked the beginning of the Nasdaq bear in march/april 2000.

  3. 3 AB

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    Lowry’s has a poor track record when it comes to good timing; they were completely skeptical of the rally off of the March 2009 low, saying that “never in their history had they ever seen such a low-volume rally”, and such that Paul Desmond appeared on CNBC in July 2009 and said that the markets were going to test those lows. They eventually brushed aside any fact that they were wrong by ignoring the fact that they even said it and then enthusiastically said that the markets were in a strong uptrend. In July 2007 they gave their sell signal and ended up being 3 months early.

    Timing the market is not easy but for the price one has to pay for their service, there are better timing models out there if one can figure them out.

  4. 4 Rod

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    Babak,

    With all due respect, this is a very one-sided interpretation. Buying the dips has worked for a year, but it doesn’ t mean it will work forever.

    Anyone can see all the signs pointing to a bounce. But the question is: What are the chances of the bounce becoming an intermediate term rally. You rightly point at Lowry’s, whose Buying-Selling Pressure indexes have already turned bearish. So the odd’s are for a short-term bounce followed by a deeper sell-off.

    Even you have conceded that the market action since mid April could imply a significant turning point (”A subtle shift in the balance of power”).

    Thus, keeping the short-term focus you mentioned, wouldn’t it be better to suggest that it’s time to wait for this bounce and then sell the rallies?

  5. 5 Les

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    The open quoted for the SPX and many of the indexes is not the true opening price of the index since many of the components haven’t opened simultaneously. You might try the same exercise with IVV or SPY exchange-traded funds.

  6. 6 JAC

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    Babak,

    I like your work. But, here I agree with Rod. Are you having an upward bias? The credit crisis phase II should take us at least into 900’s - don’t you think?

    Based on equity funds data, only momentum and day traders are trading this market. They are not strong hands and with weakening fundamental and technicals, we should surprise bulls to the downside - not bears. Disagree?

    Picking price levels is not a great exercise, but

  7. 7 Babak

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    JAC, perhaps but even Marc Faber who is a rabid bear agrees with me - at least for now.

  8. 8 Jimmy

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    the intermediate term is still questionable but no doubt we are due for a short term bounce..maybe a good one. I’ll see if the SP500 can take out the 1140-1150 resistance (and potential H&S pattern.)

  9. 9 Joe

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    Babak, can we have a follow up on this pattern in a few days? I noticed this pattern as well, but couldn’t convince myself to trade it. After follow-on day 1, it looks like a good decision.

  10. 10 Babak

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    Joe, sure thing. I love being proven wrong :) But seriously, all I’m doing is following the same set of indicators that have guided me fairly well so far. I try to remove ‘gut’ feeling as much as possible or in the case of sentiment, use it in a contrarian fashion. If anyone has a rationale for lower prices in the short term, I’ve love to hear them.

  11. 11 Rod

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    Follow up for today: The S&P 500 was unable to close above the hammer candlestick’s top and clear the congestion at ~1080.

    From my perch, yes, expect a short term bounce, but one to be faded.

  12. 12 Joe

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    Hi Babak. I don’t care about the accuracy of predictions. I was thinking about the success rate of hammer patterns, characteristics of a good hammer pattern, what we would expect to see as confirmation (next day or several days), etc. Just a suggestion.

    Regarding rationale for not trading the pattern…. Well since 2007 we’ve seen obvious periods when the market was being driven by large external macro-economic factors instead of trading patterns. With the FXE breaking to new lows not seen in years and the FXY and $USD near their 2008-2009 crash highs, I was (am) concerned about carry-trade unwind accelerating the current trends.

    Last month I was expecting a pullback in May (completing the April “head”) followed by a building of the right shoulder during the summer. Ultimately reaching October back around the May lows (and not sold off too much for the November elections). I still think this pattern might develop.

    I certainly respect the contrarian view. It was my first instinct as well, and I was looking for confirmation today.

  13. 13 JAC

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    Babak,

    What is the significance of time in analyzing price action. Some corrections last 3 weeks and some last 3 months, depending on the event the market is pricing in.

    The spreads are still widening and stocks are in weak hands. It is difficult for me to accept Euro crisis gets priced in 3 weeks.

    if small caps break 200 day and trade down below it for a week, I would consider buying into the market. Small caps are still standing strong above 200 day even though SPY broke below it.

    Is my analysis too simplistic?

  14. 14 Babak

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    JAC, I just wrote about small caps and their relative strength so great minds think alike :)
    re the time horizon, I let the indicators tell me rather than try to impose my own view - at least as much as I can. Right now it seems like we are due for a bounce higher in the short term but I’m seeing evidence that the long term picture of positive momentum has shifted. This doesn’t mean that you don’t “buy the dips” necessarily, it just means that the bounces after the dips are weaker and shorter.

    re the Euro crisis, that has been in a slow motion train wreck for a long time and it will continue to play out. News like that are red herrings because there will always be something happening for people to point to after the fact as causation for prices. The truth of the matter is that prices make news, news do not make prices.

  15. 15 AB

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    McClellan Oscillator is bottoming out so odds favor a rally back to the 50-day.

  16. 16 Babak

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    Another big name coming out with the same thesis: Barton Biggs. For more interesting links, check out news.tradersnarrative.com

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