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’

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Welcome to 2009 and the first trading day of the new year!

The last sentiment overview of 2008 didn’t paint a pretty picture. And it seems that things have continued to deteriorate from there.

CBOE Put Call Ratio
Here’s a chart of the 15 day simple moving average of the CBOE put call ratio (equity only):

Unless you zoom out you will miss that in the past few years this indicator has fallen into a rather clear upward channel. In light of this channel, we are now very close to a bearish low for the put call ratio. As you can see, in the past this has coincided with very weak markets going forward.

ISE Sentiment
Surprisingly, just before the stock market got a year end boost - the S&P 500 rising from 870 to 930 - the ISE Sentiment index reached 206 on December 29th 2008.

The last time the ISE Sentiment index was close to this level was back on October 29th 2007 when it reached 192. Before that, the last time the call put ratio was above 200 was in May 2006, just before the market entered a period of weakness lasting until October of the same year.

If we look at the equity only ISE Sentiment data, the recent top came on the second to last day of trading of the year, on December 30th 2008 when it reached 234 - meaning that retail option traders on the ISE exchange bought over twice as many call options as put options. The last time this bearish level was surpassed was in October 2007. So obviously this is an ominous warning for anyone who is long this market.

Here’s a chart of the ISEE sentiment ratio (equity only):

Silver Lining
The only bright spot I can find in sentiment land is the recent data regarding portfolio allocation from the AAII. I’ve mentioned this before back in the sentiment overview for the week of October 3rd 2008.

According to the survey respondents at AAII, in October of last year, the retail investor in the US allocated 35% in cash, 51% equities and the rest in bonds. They have now moved to 42% cash and only 42% equities (and the rest in bonds).

This is significant because for the whole history of this indicator, retail investors have never allocated as much (or more) cash as equities. Clearly, this shows a despondency which contrarian investors spend most of their days sighing for in vain.

Although we have now surpassed any historical equivalent of an extreme for this sentiment indicator, it is interesting to note that the last two times that the allocation for cash and equities came close (but didn’t match) was in late 1990 and late 2002. Both brilliant spots to put cash to good use.

This dovetails well with some other reasons already outlined for long term optimism. It seems that we are in for a rough patch in the short term but clear sailing for those who will grit their teeth and bear it. No pun intended

With the news of massive infrastructure works and the rescue of Detroit by the US government, the stock market continues to rally. Today’s rally put the S&P 500 index just barely above the previous swing high. We now have a higher low and it looks like the market is working on putting in a higher high to cement a change in trend.

But when I looked at the moving average of the daily advance decline numbers, I was shocked to see just how overbought the market is. Take a look at the data for the NASDAQ:

By the way, there is nothing magical about the number 11, I just chose it because it is short term enough to remove the lag inherent in any moving average. Here is the NYSE data for the same market internals, which show that we are now at levels last seen back in the summer of 2003 and 2004:

While this does mean that we are extremely overbought at the moment, it doesn’t automatically follow that this is bad news for the bulls. While I was entertaining these thoughts, Jason Goepfert wrote at SentimenTrader.com that:

There have been 13 times when the 10-day average of the ratio has been 63% or greater, and today’s reading was 79% or higher. A month later, the S&P 500 was positive all 13 times, averaging +4.8%. Three months later, it was still 13-for-13, but the average return climbed to +8.6%.

Lowry Research continues to be skeptical that we have seen the bottom. But more and more “experts” pile on. Just recently, Fleckenstein announced that he would be shutting down his short hedge fund and begin working on a long only fund.

The one caveat that Lowry dangled in their analysis is that the market needs to show follow through. In previous rallies it just couldn’t put together a decent push higher. But with sentiment becoming more pessimistic as the indices continue to climb, we may just have the right sort of environment for that.

How’s this as a strange contrarian indicator for the Chinese stock market? This is a billboard advertisement for Yinji Shopping Mall in Zhengzhou featuring a hanging mannequin next to a graph of the stock market:

The agency behind the billboard explain that they are making fun of the Chinese stock market. In Chinese, the billboard reads:

It’s better to invest money here than put it into the stock market.

What I’d like to ask the agency is why do they have the graph going up if they are making fun of the market’s fall?

The Shanghai Composite has fallen 72% from its high on October 16th, 2007. Compare that with 45% for the S&P 500 Index (from its high on October 2007 to the low in October).

This mention of Chinese stocks in the most recent edition of Barron’s caught my attention:

We have 10% of our equity holdings in companies outside the U.S. We have a huge database covering 59 countries and every stock with a market cap of more than $200 million. One of the countries that looks really interesting is China. There are still 214 Chinese companies that have more than $1 billion in market value. The mean P/E on those stocks, as of last week, was 13, down from a peak in 2007 of about 56 times.
In China, you are going to see slower gross-domestic-product growth of maybe 5% or 6%, down from 9%, but there are some extremely attractive values there. And although people say you are trying to catch a falling knife, the Shanghai index is down 75% from the peak in October of last year. So China has become our largest holding in terms of emerging markets.
Steve Leuthold

Leuthold is one of the “greybeards” - market players who have seen and know a lot. So you’ve got to respect his views, even if you don’t defer to them.

Way back in May 2007, much too “early”, I began to suspect the Chinese equity markets were in a speculative bubble. When the Chinese government increased the stamp duty, for all intents and purposes, it was the death knell for the Chinese stock market. It took a few months and prices went parabolic in those final months - as they always do just prior to an implosion.

Previous bear markets:
Measured by the Shanghai Composite, here is a list of previous declines from the year the market topped to how much it fell:

1992 — 72%
1993 — 77%
1994 — 49%
2001 — 55%
2008 — 72% (so far)

Here are a few ways to get Chinese exposure:

• Morgan Stanley’s China A-Share Fund (CAF)
• Taiwan Greater China Fund (TFC)
• The Greater China Fund Inc. (GCH)
• China Fund Inc. (CHN)
• JF China Region Fund Inc. (JFC)
• SPDR S&P China ETF (GXC)
• iShares FTSE/Xinhua China 25 Index (FXI) — Edit: thanks Greg

All except the last are closed-end funds, so they may not trade at their NAV. Also, CAF is the only way I know that outsiders can get in on the A-Share’s market.