Trader’s Narrative

On returning from hiatus last week, I promised to give you the broad strokes of the market: then and now. There are a lot of different technical measures I could point to but in trying to keep things simple and provide a context, I found myself returning to one of my favourite market internal measures: the percentage of stocks above their moving average.

The first chart shows the portion of stocks within the S&P 500 Index (SPX) that traded above their respective 50 day moving average. This internal market statistic has gyrated from extremes several times within the past two years. On several occasions it has hit extreme lows, which not by chance, coincide with intermediate swing lows in the market.

But while the market hit extreme oversold areas, the rally that followed was the important litmus test. And if we look closely, we see that each successive oversold level was followed by a weaker and weaker rally. The bears appear to be grinding the bulls down.

Take the first instance in early March of 2007. Only 25% of S&P 500 stocks were above their 50 day moving average when the market stopped going down. The resulting rally took that number to 85% by the end of the next month.

Over at the price chart, by the end of April, the S&P 500 had recovered all the ground it had lost. Then it continued to rally, gaining an equal amount on top of the recovery. This is normal for a healthy bull market:

Now compare this to the next time the market became oversold in late July and mid-August 2007. The percentage of stocks trading above their 50 day moving average temporarily spiked below 10%. A rare feat. And as it usually has historically, this caused a rally.

But the bulls were able to recover the lost ground and a smattering more - before being pushed back in October (green arrow above). This time, the rally didn’t continue.

You can go through the next 3 examples yourself and see how prices recovered less and less with each instance of extreme oversold readings.

Notice especially how in January 2008, although there were again less than 10% of stocks above their medium term moving average, the ensuing rally was so weak that it didn’t even go above the previous swing low. And so, the market had a lower low and a lower high (red dashed line).

Extreme oversold conditions are a great opportunity for the bulls to fight back. The “value” buyer steps in and creates a floor. The momentum trader then steps in and creates a virtuous buying cycle for others.

An oversold extreme is not automatically reason enough to buy. This depends on the tone of the market. Which is only truly revealed when you observe how the market behaves after it gets oversold.

So here we are, heading into the weakest month of the year, with lukewarm sentiment and a market that seems to be looking for any excuse to meander lower.

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.

LowRisk is probably one of the least known and followed investor sentiment surveys.

It is a bit of a mystery how large the sample size is because Jeff Walker, the person who runs it, won’t disclose how many respondents he gets or has gotten historically. In any case, all we can do is take the data and see if it provides an edge or not.

Every week, anyone with a computer and internet access can fill out a simple question:

How do you think the DJIA will perform in the next 30 days?

• Up 2% or more
• Flat (less than 2% up or down)
• Down 2% or more

There’s also another metric where they ask you to “guess the Dow”. LowRisk has been collected non-stop since 1997 and has proven to be a good contrarian measure.

Which is why it is notable that for this week it flipped from a neutral reading to a very bullish one. Right before the recent market swoon (June 3rd 2007), LowRisk showed 40% bulls and 34% bears.

But on June 10th 2007, there were 14% bulls and 60% bears.

That is very extreme. Even for LowRisk which is one of the most volatile sentiment surveys. In fact, there were only a handful of times in the past with such few bulls:

March 27 2005 —- 14.50%
July 25 2004 —- 14.30%
August 21 2005 —- 12.10%
April 18 1999 —- 12.00%
October 17 2004 —– 10.50%
September 19 1999 —- 10.30%
September 9 2001 —- 10.30%

During those past instances it did a spotty job of pinpointing great buying opportunities. Almost all of those dates correspond to a small bounce, but they were usually followed by a much better buying opportunity (lower bottom) in the immediate future.

There is another way we can slice and dice the data. Lets look at the bull ratio: bulls divided by the bulls plus the bears. This way we compare the two extremes and take out the neutral bystanders.

By that measure, the latest bull ratio of 18.9% is also one of the lowest historical instances. Here are the other times that the bull ratio was lower than 20%:

September 2 2001 —- 12.20%
September 19 1999 —- 13.84%
October 17 2004 —- 15.35%
August 21 2005 —- 16.64%
April 18 1999 —- 17.65%
March 9 2003 —- 18.06%
March 18 2001 —- 18.20%
September 25 2005 —- 19.37%
March 27 2005 —- 19.46%

As you’ve no doubt noticed, there’s a lot of overlap between the two lists. So what I said above applies to this list as well. The only standout date, because it turned out to be an amazing time to buy, was March 9th 2003. This was the third and final retest of the bear market bottom, just before the lift off to a new bull market.

Now the caveat. This is the most bearish (therefore bullish by contrarian analysis) sentiment measure. But it is just one data point.

Also, as I’ve mentioned before, LowRisk is very skittish and jumpy. Which is why it is usually smoothed with a short term moving average. Right now, its moving average is still in neutral… although with a few more numbers close to this extreme low and we’re going to see even the moving average reach extremes.

What a day to be away from the market! I left just before 2pm … sigh…

I can atleast take solace that my bullish bias was vindicated. And I think it’s safe to say this was a 90-90 day, as per Lowry’s definition. This reminds me of what happened last summer and what I wrote then. If you listened, you made some ching. If not, there is this opportunity now. Take a look at the breadth numbers for today:

If you’re not familiar with the Lowry’s 90-90 day concept, I’ve attached their 2002 report: IDENTIFYING BEAR MARKET BOTTOMS AND NEW BULL MARKETS by Paul F. Desmond (pdf).

Also, don’t forget to read what Mark Hulbert says about today’s market action from a similar perspective.

Tomorrow is the start of the famous San Fermin festival in Pamplona, Spain. Bulls will be released into the streets and couragous reckless young men will try to run with them. The trick, I’ve been told, is to not get in their way since when the bulls start, almost nothing can stop their herd mentality to just keep running. Something similar is afoot on Wall Street. But very few people are really paying attention and they may ‘get in the way’ of the bull.

We’ve just had a very rare market occurrence recently. Within a two week span, we’ve seen stocks on the NYSE receive more than ten times as much volume in advancers than in decliners. The first instance of this was on June 15th with an astronomical 22 times multiple and the second on June 29th with 12 times multiple.

This is similar to the Lowry’s 90-90 days, however, it is an older concept developed by Martin Zweig in his book “Winning on Wall Street“. According to Zweig, a stampede by bulls into the stock market has launched every single major bull market and intermediate term rally. But a double occurrence of 10 to 1 advancing volume is especially significant since it happens infrequently.

This signal is even more meaningful after a significant decline in the market. Jason Goepfert, of SentimenTrader has looked back to 40 years of market history and isolated similar situations. Here are the results:

Even more interesting is that there is almost no negative incursion after the signals. That is to say, almost all occurences show a strong bullish bias with almost no real draw down.

According to Ned Davis Research, returns after a 9 to 1 up day are similarly bullish, showing a 7% rise over 3 months and a 12.6% rise over 6 months: