Trader’s Narrative

To catch up on what you missed and to prepare for next week, here are just a few picks from the past week’s reading list at news.tradersnarrative.com.

• “Dumb Money” by Daniel Gross (look forward to Ritholtz upcoming book)
• US Tax Burden Near Historic Low (what? didn’t hear you, too busy teabaggin’)
• Get a 120 page report FREE from Global Market Perspective (limited time offer)
• David Tice: S&P 500 set to plunge 62% - that’s a real bear!
• Cramer attacks Jon Stewart for ambushing him
• Get a Free Subscription to Futures Magazine
• Yale economists discuss the financial crisis & Geithner’s response (must see video)
• Why we should have not only saved Lehman Bros. but invaded it.
• Warren Buffett’s investment in a Chinese electric car company
• Where in the World is Paul Volcker? and why is he so quiet?

Follow the link below to get much, much more:

And remember to check regularly since there are new links added everyday.

Week Ahead: US Results, Data Dominate

I have a nagging feeling this week will be one to remember. Whether it will be the bulls or the bears that will look on it fondly, only time knows. Here is this week’s unforgettable sentiment recap:

Sentiment Surveys
According to the Investor’s Intelligence survey of newsletter editors, we already had a dearth of bullishness, but now we have historically low numbers: 31.1% to be precise. Since stock newsletter editors are usually an upbeat lot, this is actually the lowest since October 2002 and early 1995.

Not to be outdone, the AAII survey of retail investors is showing that this week, 59% of respondents are bearish. We’ve been here before; at the beginning of the year. Lets see if this time we can light a flame under this rocket.

CBOE Put Call Ratio
Although the VIX rose moderately, thanks to the panic caused by the Bear Stearns (BSC) debacle, the CBOE (equity only) put call ratio zoomed above 1.16 - and I thought last week’s four year high was special!

Hulbert Stock Newsletter Sentiment Index
Mark Hulbert tracks newsletters in general but he also has a sentiment measure based on a sub-set of stock newsletters which time the market. This HSNSI is usually a fantastic contrarian indicator since editors tend to en masse, lose all hope when the market is carving out a bottom. And they tend to be euphoric when the market is about to have the rug pulled from under it.

Although this sentiment measure has been negative for some time, it is now showing real fear. This week it reached -22.5% which means that the average timer is recommending their clients short this market with more than a fifth of their money.

The really bullish significance of this is that in contrast to now, the last time the market was at these levels in mid January, the market timing newsletters were quite nonchalantly looking over the precipice. The fact that they have now soiled their pants (sentiment wise) provides us with a higher probability that the double bottom will hold.

To find a lower sentiment reading from the Hulbert newsletter sentiment index, we’d have to go back all the way to 2005. More specifically, to early May and mid October, 2005 when the market made two important lows:

“Dumb” vs. “Smart” Money
These are two proprietary indicators from Jason Goepfert that amalgamate several sentiment and technical indicators. The “Dumb Money” indicator fell on Friday to 12.5% which means that to find it a friend, we would have to travel all the way back to early 1995 and August 1998. You remember the summer of 1998, right? when we were suffering through the Asian currency and LTCM crisis? …good times, good times.

According to Jason, the gap between the two indicators is also as wide as it has been since 1995 and 1998. Pull up some long term charts and you’ll see the significance of that.

Consumer Sentiment
Although it would usually make big headlines, the results of the Reuters/University of Michigan Surveys of Consumers got buried amid the panic over Bear Stearns today. Consumer sentiment continued to decline to 70.5 - that’s the lowest reading in 16 years!

Like most sentiment measures, this one should also be taken with a spoonful of contrarianism: up is down, down is up. Which means that when consumers are most pessimistic, we have the best opportunity to go long. And when consumers are on average jumping for joy, we have to batten down the hatches.

News Headlines & Covers
Getting your umbrella out will do you no good. We have a torrential downpour of negative news and depressing headlines. To see what I mean, open any news website or newspaper. It is all doom and gloom. This or that hedge fund going belly-up, Bear Stearns pushing up the daisies, the mortgage market collapsing, the credit market in a spasms, consumer sentiment tunneling into the substrata, etc.

Even after the remarkable 90-90 up day we had on Tuesday, the majority are denying that it could potentially have any real bullish portent - although historical precedent says otherwise.

Here are a few recent covers from Business Week:

Double Bottom Thesis
One of the technical patterns everyone has been watching for during the recent market action is one of the most common and well known ones: double bottoms.

Thanks to yesterday’s rocket ride, it looks like this pattern now has a chance. What we need to look for next is that the low isn’t violated (obviously!) and two, that we can successfully take out the resistance levels just underneath 1400 on the S&P 500 index.

Lowry’s 90-90 Day
Everybody is emailing me asking if Tuesday was one of those famous Lowry’s 90-90 up days. I don’t have confirmation from the keeper of this measure but I’m 90% (no pun intended) sure that it was indeed a 90-90 day. It certainly looks like the market is getting ready for a running of the bulls.

In case you’re unfamiliar with the nomenclature, a 90-90 day is when we have such a lopsided day in the markets that 90% of the volume and 90% of the points are on the same side (either up or down). Research by Lowry’s has shown that historically, important market inflection points are preceded by extreme crowding to one side, then the other. If you’d like to read the original version (and save $10) download the research paper from my free trading resource section.

The best scenario for the bulls would be another extremely strong day which would be as or even more lopsided than yesterday’s. If we get that within a reasonable time, like a week or two, the chances of a solid bottom increases exponentially.

Sentiment
Yes, I know I’ve been harping on this for a while now but until recently we hadn’t really seen any truly extreme readings in the usual sentiment measures. Sure, they were gloomy but now we’re finally seeing some bearishness of epic proportions. This is a vital element, as the market approached the January 2008 lows, to determine if we are going to simply cascade lower or carve out a double bottom.

I’ll write up a full report covering the various sentiment measures in detail for the weekly sentiment overview on Friday.

Put Call Ratio
We had a historic reading in the commonly followed CBOE equity only put call ratio - the highest in years. As I mentioned then, for some strange reason, it seems that an inflection point doesn’t coincide with such panics in the option markets but instead follows a few days after. Well, it is a few days later.

Percentage Above Long Term Averages
This market is oversold. Is that too simple? Here’s a weekly chart of the small caps, Russell 2000 Index (RUT) showing the percentage above their 150 day moving average:

And here’s a daily chart of the large caps, Dow Jones Industrial Average (INDU), showing the percentage of stocks above their 200 day moving average:

The last time we had 10% of Dow Jones components trading below their long term moving average was when we were just finishing up the bear market of 2002-2003.

“Dumb Money Confidence”
One of the most important proprietary indicators that I watch from SentimenTrader.com is the “Dumb Money Confidence” index. It is an aggregate of many indicators and along with the “Smart Money Confidence” it shows where we are along the market cycle.

The most recent reading is 13 (the indicator runs from 0 to 100) which is extremely low. This is a result of the abysmal sentiment out there but it also reflects how extremely oversold we are now. The previous times we’ve had such a low reading has been in August 1998, October 1998, September 2001, July 2001 and February 2003.

Financial Sector
Since a huge portion of this market decline is related to financial stocks (through the mortgage credit crisis), it is vital that they be the ones to lead any rallies. We’ve seen this sector jump around on the rumor du jour but what we really needed was something substantial.

Which we got on early Tuesday. While the general market rallied 3%, financial stocks were up 7%. This was an obvious reaction to the Federal Reserve’s new $200 billion intervention. The number is puny compared to the nominal amounts at stake in the financial markets. But what is important is that for the first time during this crisis, the Fed is using a scalpel rather than a sledgehammer.

Stock and Bond Dislocation
I’ve already mentioned that these two important markets were becoming more and more dislocated: stocks were cheap and bonds expensive When the two markets become disjointed it usually flags an important inflection point.

okay, lets get started… here is this past week’s sentiment overview:

Retail Investors Soil Pants
That’s not the sort of headline you’ll find in any newspaper but it is true nonetheless. The most eye popping sentiment data this week comes from AAII where only 20% of the survey respondents are bullish and 59% are bearish.

The last time we had so small a group of optimists was January 1993 and May 1993. But even then, the number of undecideds was larger. Right now we have as severely a lopsided sentiment picture as ever. The “dumb money” is crowding to one side. The question is, where do you want to be? with them? or on the opposite side?

Before you answer, check out the chart of the S&P 500 Index (SPX) showing what happens when we have more tan 50% bearishness in the AAII survey:

I may have been a bit early when I wrote “Time to Buy” but I did add that a market rally was around the corner. I think we’re rounding that corner now.

ISEE Sentiment Index
At the start of the year I got concerned that the retail option traders were too excited, buying up calls and shunning puts. We now know that the market dipped right after. Yesterday the ISEE Index pulled back to 72 - meaning only 72 calls are being bought for every 100 puts.

That’s not as low as I’d like to see it but the market has turned around at these ratios before. Check out my intro post on the ISEE sentiment index.

Fed Rumours
Of course, it didn’t hurt that there were pervasive rumours of a surprise Fed rate cut this week. Who knows who starts these things? eh, Doug Kass? I wonder if you know?

And wouldn’t you know it? In a Washington speech, Bernanke practically came out and said that rates would be cut more aggressively - “Fed speak” for half and 75 basis point cuts. Which is what I’ve been droning on about for too long.

From a historically low reading of 10 earlier in the year, volatility as measured by the CBOE’s VIX has all but tripled. On Friday it closed lower but intraday it reached a high of 29.84.

That’s high both on a nominal basis and relative basis (see graph below). In the preceding two corrections, volatility only reached 20 something. And relative to its 50 day moving average, volatility is now about as stretched as then.

This is par for the course when we are operating with a correction thesis. Volatility spikes, the market gets spooked, smart money moves in (hopefully you) and the market resumes its merry way upwards.

But a funny thing happened that is giving me concern about this recent volatility spike. Funny as in weird. Not ha-ha.

VIX Futures
A little over 3 years ago, the CFE started trading in VIX futures. This allowed people to go long/short “pure volatility” for the first time. So we now have a futures market in volatility itself. And we can analyse this market like any other futures market.

Although we have limited history, what we see in market corrections is a move by the commercials to reduce their long positions in volatility and a concomitant move by the retail crowd (small speculators) to increase their long positions. A good example is last summer’s market action in June.

Smart Money vs. Dumb Money
So it is a bit disconcerting to now find the smart money commercial players in this market actually going more and more net long, even as the VIX has increased. And to kick things up another notch, the dumb money, small speculators are now extremely net short.

Perhaps the commercials are hedging some of their gargantuan net long index futures positions? or perhaps some other wrinkle is in the works? One solace we can cling to is that the only other time when the commercials and small speculators were this long/short in the VIX market was in July 2006. Which worked out just fine as the market continued to recover and roar higher.

Whatever it is, I’d still prefer to see the commitment of traders in the volatility futures market acting according to its past script.

Hat tip to Jason Goepfert at SentimenTrader.com