Trader’s Narrative

I’ve been yammering on about market bottoms, bullish indicators and contrarian sentiment and other similar ideas for some time. The only thing I haven’t done is reach through the monitor and slap you around till you get some long exposure

Today money flowed into advancing stocks to a staggering degree. As measured by volume, advancing issues were 3.5 times the declining ones on the NYSE and 8.3 times on the Nasdaq. That’s short of the sort of stampede that gives us the rare and valuable 90-90 days but there was no question buyers were in control.

Yesterday’s market action was similar although much more muted. Coupled with Monday’s hammer candlestick, we now have 3 consecutive up days. It would seem (if I may count my chickens before they hatch) that we are having a successful retest of the mid January lows above the 1320 S&P 500 level.

You’d think that in a such a scenario people would be bullish, or atleast a bit excited, right?

Turns out that while the market has been going higher, people are actually not excited at all. In fact, they’re slightly more bearish! Check out this chart comparing the S&P 500 index (candlestick) with the CBOE equity only put call ratio (line):

Take yesterday as an example. While the S&P 500 reached 1360 and managed to close up 0.93%, the CBOE equity only put call ratio went from 0.68 to 0.78 - meaning that people bought more puts than the previous day. Also, the ISEE Index dropped from 115 to 82 - meaning that people bought less calls than the previous day.

Today the market went up another ~1% and we had the CBOE put call ratio drop ever so slightly (almost unchanged) and the ISEE Index dropped again, from 82 to 72. That’s equally as pessimistic as February 5th, when the market fell 3.2% in one day!

Of course, the usual and expected pattern is for option traders to buy calls when the market goes up and to escape into the shelter of puts when it goes down. The opposite happens from time to time and I don’t want to read too much into just two day’s worth of data but nevertheless, it is noteworthy.

It would be very normal for the market to pause and digest this short term move up but the negative sentiment is undeniable. And it is congruent with other things I’m seeing. For example, most of the email I get is about how we are about to fall again and how the “bulls are going to get slaughtered”, etc.

The market can be a sadistic vixen, exerting maximum pain on the maximum number of people. That’s when it pays to be in the minority.

So was that capitulation? I don’t mean today’s gangbusters market. I mean yesterday’s rollercoaster ride.

Let’s see…

Stop, Hammer Time!
The intraday reversal gave us a beautiful, textbook hammer candlestick. Using the traditional Japanese candlestick theory, after a downtrend this is a portent of the end of selling pressure. Although the low could be tested - especially with Friday’s gap - a hammer is a bull’s friend.

Market Internals
The market was deeply oversold. The NYSE cumulative intraday TICK reached levels only seen right after September 11, 2001 and during the bear market bottom in the summer of 2002.

The New High Lows Index for Nasdaq reached 2.29%. Simply put, almost no highs, and almost all lows. To find a more extreme reading, we’d have to go back to the fall of 1998. Which as you know was a major market bottom.

Only 9.4% of the stocks in the S&P 500 index closed above their 50 day moving average. And only 34% above their 200 day moving average. The NYSE McClellan Summation index got as low as it has been since the bear market bottom.

My Kingdom For T-Bills
During Thursday’s nail biter of a session there was an exodus from anything risky towards the least risky asset. Theoretically risk free Treasury Bills. The run on government paper pushed the yield down to 3.86% for 3 month bills. To make things worse, due to an unexpected rise in tax receipts the government issued less paper. This sudden imbalance is extremely rare. And it only happens during panics (which… say it with me now… form bottoms).

I felt uncomfortable agreeing with Cramer, but I think this is one of the reasons why the Fed acted this morning. Commercial paper was being shunned. They stood up and basically told the market We got your back. For a bit it was touch and go, but my world feels right as rain again.

Margin Bulletin
I got a message from my broker warning me that positions in VIX futures and futures spreads could face an increase in margin from the CFE. I’m thankful for the headsup but I don’t trade these securities. I did notice that margin tweaking is a sign of inflection points. Just something to tuck under the hat.

Retail & Institutional Fund Flows
This is fascinating. According to the estimates from TrimTabs, we just had the highest weekly outflow since right after September 11, 2001. For about two years now the US mutual fund investor has been shunning the US stock market. But this week they pulled $12.8 billion out of US equity mutual funds.

According to TrimTabs, since the beginning of year, mutual fund buyers have been net sellers of stocks resulting in outflows of $35 billion in the last 4 months. The only time we saw similar outflows of this magnitude was during June 2002 and September 2002. You know what that was, right?

Strangely enough, bonds are the most popular asset class along with money market funds. They are even more loved than international markets. Bonds have seen an estimated $92 billion inflow since beginning of year this year.

That’s the retail side. What about the institutional mutual fund asset allocators? I’ll give you one guess.

They’ve been diving into the US market with the same intensity as the retail side has been escaping from it. So the smart money is buying and the emotional, dumb money is selling. Watch the video for more details:

Commitment of Traders
The most recent COT report dovetails with the fund flows data. We are seeing a continuation of the commercials going huge net long and the small speculator going the other way. Whether the futures market or the stock market, the two sides have clearly outlined their positions. There is no doubt where they stand.

What, Me Worry?
Which gives me a possible explanation for the sentiment picture. Perhaps the reason we are not seeing a total all out panic and despair from the retail investors during this downturn is that they simply don’t have any real vested interest in the outcome.

If we go by the COT and fund flows, they have very very few chips on the table. So why would they care? why would they get scared? Most of their money is squirreled away in cash equivalent and bonds and international markets. Unlike the 2000 top, they have very little invested in the US. Why would they even really care if the US market ticks up or down a few percentage points?

I find the fractal nature of financial markets fascinating. You can look at a minute chart, a 30 minute chart, a daily chart, a weekly chart and you will see basically the same formations, the same elemental forces of support and resistance and the same setups.

As a trader, you can use this to your advantage. Switching time frames can help you avoid a “noisy” market. It’s also a great trick to avoid looking at the same charts that everyone else is looking at. It can, in fact, be an edge if everyone is looking at the 15 minute chart, for example, and you’re looking at the hourly chart or the 40 minute chart. You will see things that others will simply miss.

To illustrate what I mean, let me show you an example of a trade executed following the basic rules of the dummy trading setup: look for a thrust (expansion in price), then a contraction or pullback and hop on as the contraction is taken out by the continuation of the trend. The dummy trading setup is meant to be executed intraday but knowing the fractal nature of the markets, there is no reason we can’t trade it at a higher time level. This example is a swing trade using daily charts.

Metalico Inc. (MEA) is in the hot metals sub-sector. It put in a stable, long base for over 4 months. Then in early April it broke out with unusually high volume. It consolidated a little around the $5.25 breakout area and continued higher. If you missed this first opportunity, the next one came on April 18th 2007 as price pulled back significantly. It formed a hammer like candlestick with a very long tail. This was a tell that price was being supported as a second wave of buyers saw their chance to get in on price levels they had missed before.

The next day there was a contraction as it printed a narrow range, inside candle. This is what a “dummy trader” looks for! The break-out of this contraction (green line) then took price to the previous swing high and beyond. Notice also that the volume shrank significantly as price pulled back in mid April. This was another tell that people really weren’t interested to part with their shares but rather to accumulate more (blue rounded box).

How you trade this setup is really up to you. You can wait for a tightening of the price range or you can wait for a real pullback. Traders like Tony Oz only get in on a deep pullback, preferably all the way back to the break out price. But as you can see with Metalico’s example, you may not get such a deep pullback when faced with a strong trending stock.

I don’t think anyone can say one entry setup is better than the other. Ultimately it is up to each trader to fine tune the setup to their liking and temperment. But keep in mind that such setups are merely starting places. Take them and build on them with your own ideas.

In any case, getting back to the point about different time frames… take a look at M&F Worldwide Corp. (MFW) on a weekly chart. Yes, weekly. And then count how many “dummy spots” you notice!

After reporting a disapointing first quarter, Joseph A. Banks Clothiers gapped up today on the news that sales in June had gone up 8.5%:

The first bar was a wide range down candle. The second was an almost perfect hammer candlestick which formed close to the low of the opening range with the lower tail of the candle going as low as the opening range’s low.

From there price rallied. A good low risk entry was above the second candle (hammer) with a stop loss just below the low of the opening range. With entries below the high of the opening range, it’s important to watch how price behaves when it again reaches resistance at the opening range high.

JOSB had a shallow pull back when it got close to the high of the opening range. You can see this pullback better if you look at a shorter time frame than 15 minutes. But even on the 15 minute chart above it is visible in the fourth candle’s tail. Price then continued to advance and broke through $25.17 decisively. From then on it just kept going, reaching the 38.2% Fibonacci extension and beyond.