Trader’s Narrative

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.

You know, I’m tired of people calling the US market a “bubble” or using words like “melt-up” or “buying panic” to describe it. These sort of pessimistic adjectives belies the bearish sentiment still pervasive in the wider market. If you want to see a real bubble in the making right now, you needn’t look far: China.

The Shanghai Composite has been on a rampage. Since bottoming in the summer of 2005 it has risen ~300%. Just recently, it hit a bump earlier this year and since bottoming in early February 2007 it has risen 50% (and counting). No matter how you look at it, China has gone parabolic.

The US large caps, which are currently leading the market, have put in a tame performance by comparison. They’ve only returned about a tenth of what the Chinese markets have. Still want to call it a bubble?

Keep in mind that I’m comparing the Shanghai Composite to the Dow and not the Shenzhen. That would make the comparison even more ridiculous since it has risen ~70% since its February 2007 bottom. By the way, this short term “speed bump” in the Chinese markets gave the world markets quite a jitter, if you recall.

Click to enlarge graph:

I’m not concerned about the US markets. But I am rather very concerned about what the Chinese bubble could mean for them. Technically speaking, the Shanghai market could fall 1000 points or about 25% and still be in a long term uptrend. How do you think the world markets would react to such a drop? what if it comes in a very short time?

The other reason I’m concerned is that the Chinese market, unlike the US markets or any of the other well established global financial markets, are riding on fumes. There is no substance behind the companies. Most of them are shells. The banks are in terrible shape. And most of the demand is internal with Chinese funnelling millions of Yuan towards a thinly veiled form of gambling.

When the Chinese bubble ends in tears (and it will… they all do) the Chinese market’s correction back to reality will effect the US markets more than anything stateside. This is something most people, both permabulls and permabears, are not yet cognizant of.