Trader’s Narrative

Monday’s jarring market woke everyone up from the snooze fest we’ve had to endure recently. The 500+ point drop reminded those who were around then, of the 1987 crash. But of course, there was a world of difference between the two Mondays. Today’s bounce is, believe it or not, the normal thing for the market to do when it has undergone a large gap down.

Whites Of Their Eyes
Finally we saw some fear in the market as the CBOE Equity only put call ratio reached above 1.18 - that’s high but not near as high as it could potentially go. Today it pulled back once again below parity (at 0.93). But honestly, no one is convinced until they see this and other fear gauges spike into the blue yonder and higher, and then remain there for two, three or more days.

Lasting bottoms are carved out of pain and a total collapse of confidence. Although the news headlines are very pessimistic and one would almost be forgiven to jump into “contrarian” mode, the sentiment gauges don’t quite show the definitive panic that must precede an inflection point. For example, according to the Hulbert Newsletter Sentiment Index, the average newsletter editor is more bullish now than at the low in July. This, even though after Monday’s close the market was lower.

The volatility indices, VIX and VXN did spike higher but again, last summer and just a few months ago in January 2008, they got as high at 37.50 - so we are close, but still not high enough.

Devastating Breadth
Taking a quick look at the market internals, there were only 36 advancing issues on the NYSE and only 390 on the NASDAQ. The declining issues dwarfed them at 2,921 and 2549 for the NYSE and NASDAQ respectively. Trading volume was so lopsided that for each advancing share there was 172 declining shares. I haven’t done the calculation to see but it looks like a same assumption that Monday was a classic Lowry’s 90/90 day to the downside.

Technical Damage
There was serious technical damage all over the place. Not the least of which was, as mentioned before, the close below the July low. But what worries me, is that although there was damage done, it doesn’t show up as extreme on the charts as the screaming headlines would have you believe. For the most part the market is still approaching a final exhaustion. Where I would feel comfortable saying that there has been a washout of selling.

And yes, this is exactly the sort of thing that happens at the worst of times, when we are close to a major bottom. But I’m not convinced we are there yet. We are close, but before we get there we’ll see more volatility.

Take a look at the percentage of stocks trading above their 10 day moving average. Even after Monday’s decline, there were 17% above this short term moving average. For a lasting bottom, I’d like to see below 10% and preferably below 5%. Or take a look at the high low ratio:

Probably the most important thing to take away is that while heavy selling is a necessary part of an change in trend, by itself it doesn’t guarantee anything. But if heavy selling is followed closely by intense and almost indiscriminate buying, then chances are it is the real deal.

It never ceases to amaze me just how horribly wrong regular people are as a group when it comes to timing the market. There is a whole cottage industry around trying to gauge their sentiment so it can be faded.

Being a contrarian isn’t as easy as simply doing the opposite of what the non-professional investors are doing though. The key is to pick your moment. You want to do the opposite of what they are doing only at extreme inflection points.

Escape to Cash
Take for example the current state of Canadian investors. In spite of seeing the market recover, they are so traumatized that cash holdings in Canadian households has climbed 15%. According to the investment banking arm of CIBC, this is the fastest pace since… c’mon now, this shouldn’t be difficult… 2002.

So Canadians are basically rocking back and forth in the fetal position. Just as they were at the bottom of a brutal bear market which cut the Nasdaq in half and decimated investment accounts everywhere.

They have cashed out $35 B of equity mutual funds in the past 6 months. And on a rolling 3 month basis, net sales of mutual funds is in negative territory (in other words, net redemptions). That is the worst state of the mutual fund industry since they have been keeping records.

Double Whammy
So on the one hand we have investors who don’t see the market correction coming, get excited and buy mutual funds. And when the market does correct, and they lose money, they are so shell shocked that they just sit there on a pile of cash while the market moves on.

The 1987 stock market crash lasted two months and panicked investors towards the safety of cash. The problem was that, according to the CIBC report, they stayed there for 16 months afterwards, missing out on an amazing run as the market recovered.

This is the sort of thing that drives regular people absolutely bonkers! The give up saying that the market is “rigged”. Truth is that money flows inevitably from weak hands to strong hands.

The good news in all of this is that with a bit of effort you can learn to zag when everyone else is zigging. This is not as simple as it sounds though. There is something innate within us that draws us to the safety of the crowd. So standing apart is excruciatingly difficult from a mental and emotional basis.

Caution, Caution, Caution
While this level of fear usually marks major market bottoms, it doesn’t mean that the stock market will go up without pause or retracement. In fact, from the percentage of TSX stocks trading above their 50 day moving average, it looks like this is just the right time to lighten up:

The fact that the market is now probably topping here does not negate the contrarian significance of the regular Canadian investor hording cash. Note that the market topped out in July 2007 and again in October 2007 without whipping the masses into a frenzy of stock buying. That is, they weren’t mortgaging their homes to buy stocks like the bubble years gone by.

And when the market bottomed in the summer of 2006 and 2007 it wasn’t enough to cause people to become shell shocked. For some reason it took the market correction in early 2008 for that. I have no idea why. Maybe it was the confluence of the housing market, the price of oil marching higher, the credit crunch, etc. All I know is that right now we have market sentiment so bearish it only appeared last in 2002.

On a related note, if you are interested in mutual fund cash levels and their significance for the stock market, check out Jason Goepfert’s award winning paper: “Mutual Fund Cash Reserves” located in the Charles H. Dow Awards folder of my free trading resource area.