Trader’s Narrative

The National Federation of Independent Business (NFIB) Small Business Optimism Index fell 2.6 points to 85.2 in December 2008:

This is an aggregate measure of 10 indicators: outlook for expansion, earnings, sales, and hiring. Amazingly, the net percentage of small business owners planning to hire is -6%. That scrapes the bottom of the barrel and is analogous to the recession we saw back in the 1970’s (not shown on graph).

Small businesses are often been touted as the engine of the US economy. From this survey it is obvious that the engine is flat out junked. These numbers are as bad as we’ve ever seen them in modern history.

The NFIB survey complements the other sentiment readings we’ve been getting from other sources such as the Conference Board Consumer Confidence and the State Street Investor Confidence Index.

You can get more information and download the full report at the NFIB site.

Before we say goodbye to not just a bad October but the worst month since the 1987, here is a quick roundup of the sentiment landscape:

Sentiment Surveys
According to ChartCraft, the Investor’s Intelligence sentiment survey shows newsletter editors little changed in their outlook this past week: 23.1% bullish and 52.7% bearish. That is still an extremely high level of pessimism for a normally cheerful bunch. Remember, doom and gloom doesn’t bring in the subscription coin.

The retail investors on the other hand continue to be nonchalant. The AAII weekly sentiment survey showed a small uptick in bearishness to 40.6% and a small downtick in bullishness to 37% but still the over all mood is way too cheerful for me. As a contrarian I’d be much more comfortable to see the average person continuing to be pessimistic about the market before getting too excited about a lasting rally.

Options Market
Like many, I continue to wrestle with the options market, trying to make some sense out of the data it generates. For more, check out not only my own thoughts about this crazy options market but some of the most respected technical analysts out there today.

The ISEE sentiment continues to be ambivalent about this whole chapter in the stock market. I have no idea why but it has totally broken down and although I continue to watch it, it is tough to ascribe a rationale for its moves or to glean a message from it.

The CBOE put call ratio (equity only) went up on Thursday and Friday implying that options traders on average were not totally buying the most recent rally.

Short Covering or Real Buying?
The reluctance to see Tuesday’s rally as “real” is shared by many. After all, the majority of the biggest one day gains in the stock market have occurred during brutal bear markets. A reader contacted me wondering if it was “just short covering” or “real”? I’m not sure if it makes much of a difference. The short interest ratio for the Nasdaq is very high, which is traditionally a bearish omen. Any other ideas on how to distinguish between a “real” rally and a short covering one?

Lowry’s 90/90 Day
The market continues to make people stare at their screen like goldfish, widemouthed and blinking in amazement. Tuesday’s rocket ride sure felt like a 90-90 up day, which according to Lowry’s research is a prerequisite for a new bull market. We’ve seen repeated 90-90 down days but finally got a decisive buying stampede. Up volume demolished down volume by a ratio of 19:1 - the most exaggerated ratio since last year.

If you still haven’t, read Paul Desmond’s seminal work in my free trading resource section (Reports & Articles)

Consumer Confidence
This should be an interesting holiday season for the retailers. The American consumer is not only incredibly dissatisfied with everything in general, they are extremely pessimistic about the future. Like so many other indicators we’ve been watching during this bear market, the Conference Board Consumer Confidence (Expectations) plunged to its lowest level ever.

That is lower than the aftermath of the 1987 crash, the bear market in the 1970’s and the public’s reaction to the tragedy of 9/11. Which says a lot. Consumers are basically shell shocked. The spending orgy, fueled by easy credit, is gone. Now comes the hangover.

From a short term perspective this may appear to be bad news but historically troughs in consumer sentiment have been a great contrarian indicator. After I mentioned it as a condition of a new bull market, it rebounded briefly but the message is unmistakable.

Greybeards
In the past few weeks we’ve seen Warren Buffett, Doug Kass and Steve Leuthold all saying pretty much the same thing: they are buyers. Which leaves one wondering. If you are going to fade these guys, you better be incredibly lucky and incredibly smart. It is possible they are wrong - but highly, improbable.

A big question on a lot of minds is whether what we are seeing is just the run-of-the-mill bear market reaction (a bear market rally or “dead cat bounce”) or whether perhaps this is the start of a brand new bull market.

While I do have some ideas, I’m not sure myself. Well, no one really knows. What I mean to say is that I don’t have a strong conviction one way or the other right now. But I’d like to change that. So this week I’m going to cover the 7 prerequisites for a new bull market as set out by Jim Stack, the writer of the InvesTech newsletter.

According to Stack, there are seven major conditions that have historically been present before we’ve launched into a secular bull market. Like most approaches to the market, these seven conditions simply allow for a list that we can check off. The more conditions are present, the better the chances that this rally is the real deal. But as always, never a guarantee in sight!

The first one I want to cover is consumer confidence, or more precisely, a plunge of at least 34 points in the Consumer Confidence Index:

Plunge in Consumer Confidence - Marked by a drop of 35 points or more. This index is reported monthly by The Conference Board and is based on a representative sampling of 5,000 US households. It’s calculated as a weighted average composed of 40% current and 60% future expectations and is commonly used to predict the future health of the US economy. For investors, it can also provide a valuable clue to identifying the “Best Buy” opportunities on Wall Street. Logically, such opportunities seldom occur in the late stages of a bull market when consumer optimism is already frolicking at lofty levels. Instead, the time to start shopping for stock market bargains is after confidence has plummeted and gloom is widespread. In each of the past 5 recessions, the Conference Board’s Consumer Confidence Index has tumbled over 34 points before a new bull market was born. Watch for a similar drop that might help to confirm the next true low-risk buying opportunity.

Here is a chart of this indicator showing a plunge of almost 50 points:

Incidentally, it is almost at the exact same level when the stock market reached its bottom in March 2003.

Here is the other widely followed consumer sentiment survey, Reuters/Michigan:

Its good to see these two surveys agree with each other so much. The Reuters/University of Michigan sentiment survey is even lower than where it was at the March 2003 market bottom. It is plumbing depths not seen since the early 1990’s and 1980’s. Curiously, back in the 1980’s, the unemployment rate was twice as high as it is now.

Anyone familiar with market history will recognize those time periods as excellent times to buy. If you’re not or if you would like a refresher, just pull up a really long term chart from your favorite charting platform.

So we can comfortably check off this condition as being met. The next one tomorrow.

Oh and in the meantime, I highly recommend you give InvesTech a look see - and no, I am not affiliated with it nor do I receive any compensation if you do.

Everything seemed to be going alright and then GE came along and whacked the markets with their largest earnings miss in at least three years.

Any way you cut it, Friday was a horrible day (for the bulls). There were 2440 issues declining on the NYSE (out of 3211) and on the Nasdaq, 2,290 fell out of 3,037 traded. Advancing volume was dwarfed by declining volume - 9:1 on the NYSE and 6:1 on the Nasdaq.

Of course, I don’t think that GE is the real cause of the market’s fall but it is a comfortable excuse for most. I outlined my hesitation that the market was approaching resistance levels and that the odd lot short sales were too high to give me reason to believe that the rally would continue.

Surveys
According to Investor’s Intelligence, newsletter editors are for the most part unchanged in their view of the market. Meanwhile, the AAII sentiment has now recovered that it is slowly approaching just a tad too much optimism: 46% bullish, 37% bearish.

The same can more or less be said for the other sentiment measures: LowRisk, Consensus, and MarketVane, so I won’t bore you with their mundane details.

Put Call Ratios
The decline wasn’t enough to push the CBOE put call ratio to parity. It climbed to just barely below 0.90 - below levels which we would associate with panic:

Before Friday’s thrashing, the small option traders as measured by the proprietary ROBO ratio had actually increased their pessimism despite the market’s recent rise. I always take notice whenever sentiment goes in the opposite direction of the market it is tracking. But again, this was before GE threw a monkey wrench into the works.

NFIB Sentiment
The National Federation of Independent Business (NFIB) is reporting that small business sentiment in the US is at an historic low. They have collected information from their small business members for more than twenty years and this most recent response is the gloomiest assessment of business outlook ever.

So it seems that the horrendous consumer sentiment has company.

As you would no doubt surmise, such pessimism is actually good for the market. Whenever we have an excessive level of doom and gloom, the worst is already behind us. I’m referring to the stock market here because while there may be real pressure on consumers and small businesses, the stock market is a forward discounting mechanism.

And because it looks forward while other indicators measure the past or present, it can seem to be paradoxically the opposite of the real economy.

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.