Trader’s Narrative

According to the percentage of Dow (Industrial) stocks above their 50 day moving average, I’m paring back my long positions here. In one month’s time, we’ve gone from extreme oversold level of 10% - reached in mid-August - to almost hitting the other extreme (see graph below). That’s a very fast turnaround which we haven’t seen for some time.

The time to go long and push the envelope was when everyone was scared witless as the volatility jolted higher, the banks and brokerages were dumped and the put call ratios spiked to panicville.

When I asked rhetorically “Was That Capitulation?” (hint, hint).

Now is not the time to jump on the bandwagon for a quick win. I’m still bullish for the long term but in the next little while I think we’re in for a bit of turbulence as the market digests and adjusts. Plus, I don’t think the risk reward is justified now when you’re already sitting on a winning position to push it further from here.

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?

During this most recent bull market we’ve had four major corrections. On average they have pulled the market down about 8%. The fifth is still ongoing so no one knows how it will turn out.

Perhaps Jeremy Grantham’s theory will be proven to be correct. Or perhaps it will be just another correction within a secular bull market. I’m trying to remain agnostic and unemotional.

This Time Is Different?
I’m assuming that we are witnessing a fifth correction and my reasoning is that it makes sense to continue doing what works, until it doesn’t. If you buy every correction in a bull market you’ll be wrong once - at the top. I’d rather have the market prove me wrong and deduct that tuition from me than to automatically think “This time it is different.”

So far this most recent correction has exceeded not only the average of the previous corrections (-7.8%) but also the deepest one (-8.8%). As of yesterday’s close, we have seen a -9.6% correction, which by the traditional definition of a correction is barely adequate.

Theoretically we could correct another 10% with the bull surviving. But like little rich kids, we’ve been spoiled with these relatively shallow pullbacks (see graph below). What worries me the most is that we are dripping lower slowly and not falling throught the floor.

Brother Can You Spare Some Capitulation?
Sentiment is probably to blame as there is still no capitulation. We saw the put call ratio spike up but then even after yesterday’s severe market decline the equity only put call ratio came down slightly (from 1.08 to 1.05). That is troubling. On the plus side the ISEE sentiment did fall double digits but it still is not in the 50-60 range that I’d like to see.

Here’s a graph of the bull market corrections:

Alright, so by now we know that the ISE sentiment data on the official webpage is wrong. Thankfully I was able to correct it as best as possible. It helped that only the past few data points are suspect.

In any case, seeing how the ISE sentiment helped me turn cautious just at the top of this market swing, I’m not giving up on it yet.

But I’m reduced to using my own graph (see below) as their’s is wrong (and still neither corrected nor noted as such). Sheesh. I hope they get their act together. So the chart uses correct data (as far as I can be sure) not that crazy 51 data point.

I looked at the 10 day moving average as my guide, just as before. This time however this short term moving average is saying that the ISE sentiment index is about as low as it has been. Other than the March 2007 bottom, to find a similarly low reading we’d have to go back to the end of the bear market.

I’d still like to see atleast one day of major capitulation showing up on the ratio. Something in the range of 50-60. And atlhough we may get it, it may not be necessary. Rather than a whoosh down which has been the script so far, we could just meander and muddle through for a bit as people are bored to death rather than scared to death.

Click To Enlarge Graph:

Thin green line is the 10 day moving average of the ISE Sentiment Index while the thick blue line is evryone’s favourite market proxy.

Arguably, the biggest chink in the armour for bulls is the lack of extreme bearishness in sentiment that would give way to an outright capitulation by sellers. When I listed the 12 Reasons Why This Is A Buying Opportunity two days ago, sentiment survey results hadn’t really come in yet.

They’re now in and we can take a look at how market participants reacted to the decline. (I already covered LowRisk, so I’ll skip to the others.)

Investor’s Intelligence
The recent II results show 47.2% newsletters as bullish, down 6.7% points, and 26.4% newsletters bearish, up +8.4% points. That’s the direction that I’d like to see sentiment heading in. But the degree to which newsletters gave up their bullishness is still not enough to cause a wide enough swing to take us to a contrarian bullish level. While just before the market tumble, it was way too bullish, II is now, at best, mired in neutral territory. So it isn’t much of a help. Except to show that we still don’t have capitulation.

AAII
The AAII survey is equally lukewarm. Bears increased by 3% points to 40% and bulls increased by 2% points to 46%. The bull ratio hardly budged. Not at all the sort of sentiment reaction I was expecting. Especially with the plethora of negative headlines and news reports about the market and its scapegoat, the subprime mortgage market.

ISE Sentiment
In early March 2007, we got a cluster of 3 back to back readings in the 60’s. Meaning that approximately 60 some odd calls were purchases for every put on the ISE. Right now, we’ve only dipped to 78. And today, eventhough the market closed very weak, the ISE Sentiment Index jumped 25 points to 103 - so as the market went down, ISE traders purchased more calls. That’s not capitulation. That’s stubborn bullishness. And frankly, it punches holes into the bullish case.

Put Call Ratio
Similar to the ISE Sentiment index, the put call ratio oddly shows a dangerous amount of complacency. Even as the market sliced through its support area this afternoon, I can find no real rush to buy puts. It seems that traders are comfortable with the declines. And if there’s anything that should send shivers down the backs of bulls, it is that.

I’m actually a bit confused about this because the last time I checked in on the put call indicator, it was showing an extreme spike. But now, it seems that it was an error, either from the exchange or the datafeed provider. In any case, eventhough the put call ratio is in the “green” zone, it still hasn’t shown the kind of whoosh I’d like to see (the kind that gives investors reason to change their pants).

Conclusion
One, I better start double checking my data! Two, we do not have capitulation from these sentiment indicators. As long as they show a comfortable and complacent market, the probability of a continuing decline increases.