Trader’s Narrative

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Granville said it best in his book, A Strategy of Daily Stock Market Timing:

“When it’s obvious to the public, it’s obviously wrong.”

Since we talk a lot about sentiment and contrarian sentiment, lets step back and review where this idea came from and how it developed from its origins.

Charles H. Dow
The main principle behind contrarian analysis and sentiment (two sides of the same coin) comes from Charles H. Dow’s work on distribution and accumulation. The same ideas that underpin the Dow Theory. I’m sure you’ll also notice the similarity between these ideas and Weinstein’s stage analysis which breaks up a movement of a security into four parts.

According to Dow Theory, major market movements start with an “accumulation” phase where insiders, and other knowledgeable traders or investors start to buy shares. Since at this point the average public sentiment towards the market is negative, they are able to accumulate shares without significantly pushing prices higher.

Eventually the general sentiment starts to tip as more and more people start to realize that something has changed. This is the stage at which trend followers jump on and start to push up prices further. The trend continues and feeds on itself, perpetuating until it reaches a crescendo.
Continue reading ‘A Brief History Of Contrarian Analysis’

On Wednesday - February 13th - after 3 consecutive up days, I mentioned the peculiar way that option traders were in denial of the rally and of the likelihood of seeing a pause:

It would be very normal for the market to pause and digest this short term move up but the negative sentiment is undeniable.

We got the “pause and digest” the following day on Thursday and today. So to dive into all that negative sentiment, here is the stock market sentiment recap for this past week:

LowRisk.com
I mention this sentiment survey sparingly because it is very jittery and much less famous than its peers. But this week’s reading of 64% bears and 24% bulls reminds me of the last time that bearish sentiment was 60% (June 2007).

Unlike then, this week’s bullish ratio (bulls divided by the sum of bulls and bears) is quite high at 27.27%. But there is no denying that the respondents are very gloomy about the Dow’s prospects. Their median guess of the Dow (closing value February 22nd) was 11852 - well below the Dow’s January swing low of 11,970.

Investor’s Intelligence
If you’ve been keeping up to date with these sentiment overviews then you know that the II survey has been insistently and stubbornly stuck with a clear bullish consensus. For contrarians, that has been disconcerting not only because II is a major sentiment survey but because it contradicted all the other surveys.

This week it seems “reason” has finally prevailed in newsletter land. According to ChartCraft, the keeper of this indicator, the bears now account for 35.6%, and the bulls 36.7%. While that may seemingly put them neck and neck, the historical data for this survey gives us a decidedly more bullish interpretation.

Newsletter editors are naturally bullish by nature, after all, optimism sells. So it is almost impossible to find less than a third of them bullish at any point in time, no matter what the market condition. The current percentage of bulls is as low as it was in the summer of 2006 and 2002 (and no other time since). So I can comfortably say that the II is officially flashing a contrarian buy signal - finally!!.

AAII
Meanwhile, the AAII (retail investors) sentiment has finally decided to come up for air from the depths of despair it had sunk to in January 2008. The AAII sentiment survey spent 5 consecutive weeks (December 21st, 2007 to January 18th, 2008) being 50% or more bearish. The bears are now “only” 42% (with the bulls at 33%).

We’ll have to wait a few more months to see if the stock market follows the previous script or if we stray. According to the above chart, we could find the S&P 500 at 1558 by June 2008.

That’s not a prediction, by the way. I’m just extrapolating from the historic averages. But it could turn out to be prescient, so write it down somewhere or bookmark this so you can come back and mock me

Consumer Sentiment
The most recent Reuters/University of Michigan’s consumer sentiment survey was released today and it shows a stumble from 78.4 to 69.6 - the lowest since 1992!

As I’ve discussed before, consumer sentiment measures are a contrarian indicator. By the time they reflect doom and gloom, it is too late to sell, and in fact a better time to buy.

Whether that is because of the time lag built into this kind of survey or whether it is because of the forward discounting ability of the stock market (or both), the historical evidence shows that significant lows in consumer sentiment are buy signals for stocks.

I’ll going to write more about this indicator soon.

A quick follow up to gold and gold stocks:

Although both the yellow metal and related equities have continued to rise, something is conspiring to keep a tight lid on the rally. And no, it isn’t a wide reaching and vast conspiracy involving central banks, hedge funds, the Easter Bunny and Mossad.

Last week, gold sentiment skyrocketed to 81% - as measured by MarketVane’s Bullish Consensus. That is the highest it has been this year and not too far off historic extremes.

According to contrarian analysis, there is way too much excitement about this little latest rally. When the vast majority of those who are interested are bullish (and act on the opinion by buying) the tragic conclusion is that there isn’t any real buying pressure left to propel prices higher.

This is what happened last May when bullish gold sentiment reached a crescendo of +90%. Gold peaked at $725 and the AMEX Gold Bugs Index (HUI) at 400. Neither have seen those levels again. And if the bullish sentiment continues, there is less and less probability they will.

The only argument that I can see for a continued rally in gold is the bullish percent index for the sector. According to the BP index kept by Dorsey, Wright & Associates, there is a possibility that we could see gold break out from this multi-year trading range.

In mid August, along with the rest of the market, gold got clobbered. That caused the bullish percent for the index to fall to 16% - a very, very low number. So far, it has recovered from this depth to 30%. As you can see from the chart (below), the BP index has quite a ways to go before it reaches overbought territory.

So take your pick: keep gold longs because bullish percent is still quite low or pare positions and tighten stops because sentiment is getting too bullish. Personally, I’m going with sentiment - via contrarian avenue.

Click To Enlarge Graph:

Graph Credit:Technical Watch

Thanks to Moises, a reader in Barcelona for the link (please have a bocatta on me and don’t forget the tomate drenched pan)

Yowza! Looks like nothing can keep this maket down. Not yesterday’s profit taking, which was long overdue! And certainly not the news that terrorists are in the advanced planning stages of a hit on US interests in Germany. One way or another the market finds a way to keep going up. So let’s take an overall look at the sentiment picture out there:

AAII
After last week’s historic reading, the AAII survey this week has ameliorated and now shows a tie with both bulls and bears at 43%. The AAII sentiment survey is now neutral and the only sentiment metric out of the group which is not showing more bulls than bears.

Market Vane
Market Vane’s Bullish Consensus is calculated by going through brokerage, analyst and CTA recommendations on a daily basis. Currently it stands at 72% bullish. But since early 2004 this has had a bias towards bullishness. The lowest it has been in the past 3 years is mid-50%’s. Since this sentiment indicator can get stuck either bearish or bullish for a length of time, we have to look at it on a more relative basis.

Investor’s Intelligence
Currently the II is showing 20% bears and 53% bulls which gives a bull ratio at 0.72. This is rather high, by contrarian analysis bearish. Evenso, we’ve seen the market power ahead inspite of II readings at this level. For more information on Investor’s Intelligence.

Consensus
This sentiment survey is similar to Market Vane’s in that it is comprised of brokerages, advisory services, analysts and CTAs. And like Market Vane’s it can become mired on one side of the sentiment landscape. Right now it is at 74% bullish, which is approaching 3 year extremes. From a contrarian point of view, this is bearish for the market.

LowRisk
The LowRisk.com survey is done online each week with participants filling out where they believe the Dow Jones will finish: up 2%, down 2% or unchanged. Since this is the most jittery metric, it is useful to take a short term moving average to smooth out the data. Right now, it is sitting around the neutral zone with almost as many bulls as bears.

It is fine to look at how market participants claim they feel about the market, but we still have to look at what they are actually doing. To do that, lets take a look at Commitment of Traders and short interest data:

Commitment of Traders
This data is from the Commodity Futures Trading Commission (CFTC) and shows how small speculators, commercials and large speculators are positioned in the futures markets. Right now, the small speculator - usually the market participant to fade - is positioned short. This would be bullish from a contrarian point of view.

Public Short Interest
This data is released by the NYSE with a 2 week lag. When the public is heavily active in shorting stocks, it has usually been a very good contrarian indicator that we are bottoming. Right now though, we are seeing a derth of public short selling which has pushed this indicator to the extreme seen usually at market tops.