Trader’s Narrative

Here is this week’s stock market sentiment overview:

Sentiment Surveys
In last week’s sentiment overview, ChartCraft’s Investor’s Intelligence sentiment survey came in at a 14 year low (for bullishness). This week there were only 22.4% bulls with bearishness remaining unchanged. This week’s numbers take the II to a 20 year record! From a contrarian point of view, the message is clear.

The AAII sentiment survey is whistling a different tune however. The bears fell dramatically from 61% to 40% and the bulls rose to 41%. That’s a dramatic shift. Not only for the decrease in bears but because technically we now have slightly more optimists than pessimists. For confirmation of a market bottom and a healthy rally, I’d prefer to see continued doom and gloom.

There was a similar uplift in mood for the Consensus sentiment survey. Bullish sentiment rose from last week’s 21% to 36%. Again, not the sort of thing that gives contrarians confidence for a sustainable rally.

Volatility
Now this is just insane. The VIX closed the week at 70.33 - that is a record, in case you’re keeping track. But a new all time high record isn’t what makes my eyebrows levitate. It is that the VIX ended higher than on October 10th 2008 - when the market closed lower than on Friday. So while the market is now higher, fear - as measured by the VIX - is actually more pronounced. Interesting.

TED Spread & LIBOR
The credit markets are continuing to thaw with both LIBOR and the TED spread falling. But, and that is a big but, we are no where near normalcy. Both indicators are at extremely elevated levels. They difference is that they are now going in the “right” direction (if you are a bull). But they still have a long ways to go to totally unwind.

Sell Side Indicator
The Sell-Side indicator measures the equity allocation recommendation of the average Wall St. strategist to their clients. As you can imagine, as a group they are a great contrarian indicator just like the newsletter editors (Investor’s Intelligence) or the retail investors (AAII). Here’s a good article which explains it in more detail.

Right now the average allocation is 58% - which is the lowest level in 10 years. However, if you look back more than that, it is clear that we are near levels which would only suggest a cyclical bottom for the stock market, not a secular one (at best):

University of Michigan Sentiment Survey
If we needed another sign that the US consumer is totally pessimistic, the recent Michigan sentiment survey shows an even lower reading than the last time I mentioned it in May (Conditions of a New Bull Market: Consumer Sentiment). At 57.5%, it is now lower than anything we’ve seen in almost 30 years. This is saying a lot when you consider all the shocks that the financial markets have been buffeted with over that time:

The lowest reading in the history of the survey was in May 1980, 51.7%. This most recent result is preliminary and may be changed when it is finalized on October 31st 2008. We actually saw a lower reading than this most recent number in June 2008 with 56.4%. Then things seemed to improve to 70.3% only to fall down again. In any case, these small details matter less than the overall picture showing a shell-shocked consumer.

As you’d imagine, in the upside down world of contrarian sentiment, extremely pessimistic consumer sentiment is bullish.

Hedge Fund Redemptions
Forget mutual fund redemptions, hedge funds, the sophisticated investment vehicles of wealthy individuals and institutions is hemorrhaging assets to the tune of $210 billion. It seems most aren’t absolute return vehicles but closed index funds because in the recent quarter, they produced terrible results for their clients. According to hedge fund watchers, this looks to be the worst year both in terms of asset flows and returns.

Of course, not all hedge funds suffered. Andrew Lahde posted +860& returns and closed shop after just one year.

Here are some thoughts with my own conclusions at the end:

Ned Davis Research
A very respected institutional research house, Ned Davis’ company relies on 12 indicators covering sentiment, volume, volatility, and breadth. Right now ten are flashing a cyclical buy signal. But a unanimous result isn’t needed for it to be valid. For example, in the bear market bottom of 2002, only nine of Ned Davis Research’s indicators was indicating a buy. But they are not recommending to their institutional clients to start buying. They want to be patient and wait for a retest of the lows. If market internals are healthy on such a retest, then they would suggest going long.

Stock Market Cycle
There are patterns in the market’s history. But so far this year, the market has forged its own path. An election year should be a positive for market returns, especially in the later months of the year. But not this year.

The four year stock market cycle means that 2010 is the year to watch. But according to the decennial cycle, the 8th year in a decade has been good historically. Unless we have a miracle, this year will also be an exception. Here is the master of market cycles, Peter Eliades offering his views:

Credit Squeeze Relaxing
Both the TED spread and the LIBOR rate have receded. As well the price of “insurance” on default for banks has also dropped. There are mounting signs that we are seeing a thaw in the credit freeze that paralyzed the market. My only quibble is the short term rate (90 T-Bill rate) which continues to be pushed down. The bond market is telling the Fed to lower rates. Hopefully they will listen (unlike all the previous times) and get ahead of the situation rather than playing catch up.

Volatilitius Maximus
Volatility has been absolutely insane. There is no gentler way to put it. We’re seeing double digit (or close) moves in the market daily. It is both unnerving and exciting. And here I’m not just referring to the sky high VIX index but also to the breadth numbers which show extremes. The good news may be that such volatility has been historically associated with market bottoms. As I wrote two years ago, extremes in market breadth with the advance decline numbers swinging from one extreme to the other to gather “fuel” for a sustainable trend to be established:

Smart Money vs. Dumb Money
At every inflection point in the market, we witness the smart money and the dumb money do different things. This is how wealth is transferred from one group to the other after all. So far we’ve seen Warren Buffett extract very favorable terms with General Electric (GE) and Goldman Sachs (GS). Terms that the US government hasn’t gotten. That’s another issue though. Although you or I may not be able to negotiate the same terms, it is still valuable to watch what the smart money is doing.

Which reminds me of Tony Oz’s video where he called a bottom. Faced with a melt-up, he did what any smart trader would do, sell into the wave of buying.

Corporate insiders are also considered “smart money” and they have accelerated the rate of their purchases, pushing the buy-sell ratio to 2:1. This is very unusual because usually it is the other way around as insiders sell shares which are given to them as part of their compensation package. But caution is warranted because insiders are notorious for being early to the party - as much as one whole year.

The other end of this see saw is to watch the “dumb money”. I’ve gone into detail over the past sentiment overview regarding the public’s and retail investor’s pessimism during this crisis so I won’t rehash it here. Now that we are getting the first glimpses of the bulls returning, the most important aspect of contrarian sentiment comes into play; watching how the “dumb money” reacts to a recovery in the markets. If they continue to be fearful and pessimistic, even when the market recovers, then the chance that it is a real floor is much higher. But if they quickly switch sides, then we will see more downside.

Conclusion
My own hunch based on all of the above and more, is that this is a cyclical bottom. It is tradeable, and the volatility provides amazing short term opportunities for trigger happy traders but we are far from a secular bottom. You’ll know we’ve hit that when stocks and the whole equity culture of the US and the world changes. When people start outright hating stocks or even the thought of investing.

When everyone laughs at you or feels sorry for you for even hinting that it may be time get back in the stock market. When the valuation pendulum swings way to the other side and measures, whether based on price earnings or price dividend are so outlandishly extreme that you do a double take. That’s when you’ll know we’ve hit a secular bottom. One for generations.

Not a moment too soon, the financial markets reacted to leadership from European governments and central banks over the weekend. Sadly, the US team of Bush (excuse me while I roll on the floor convulsing with laughter) Paulson and Bernanke didn’t exhibit one iota of leadership or common sense. Did anyone expect the same team that continuously reassured the world that everything was fine over the past 2 years to be the ones to actually solve this?

The consensus among smart economists (Roubini), investors and traders (Soros) has been the need for “capital injection” - a euphemism for “buy a truckload of financial common stocks”.

The Old World Shows The Way
The US’s muddled TARP proposal instead was aimed at buying into the nebulous and toxic derivatives at the heart of this crisis. Shares are easily priced each second on the open market so it can’t be easier to value a bank’s “worth”. Whereas the derivatives are next to impossible to untangle and value. Also, a share, because of its perpetual existence, has a multiplier effect. So by injecting $100 billion of capital, you in turn leverage the effect by the P/E ratio which even now is around 10 for the average financial institution.

Of course, by now TARP has morphed into the European model. Which can arguably be also called the Swedish model, since this very solution was used by them in the early 1990’s to get a banking crisis under control. And unless I’m mistaken, the Swedish taxpayer actually got significant capital gains out of the whole thing. Seriously, how ridiculous does Paulson sound when he proposes with a straight face to simply use government money to buy assets of dubious quality and worth… without receiving absolutely anything in return?

You don’t need a PhD in finance to know that way lies madness.

Then again, the news of a concerted European effort may simply have coincided with a snap back rally. If you recall, many had high hopes for the TARP announcement to reverse the market’s decline. It did no such thing. So in effect, while the news seems to have caused the market to rally, we can’t truly prove that it was the force behind it. There are strong reasons to believe that the market was simply exhausted from relentless forced liquidation and just hit the wall.

Timing
Last week I facetiously suggested that if this wasn’t the stock market bottom, we should flee to the hills and buy guns. The future was starting to look like some kind of Mad Max distopia, at least if you believed the breathless analysts on TV and the headlines across newspapers. Then just hours later I learned that Tony Oz had taken a large long position, based on similar conclusions.

Of course, no one knows what will happen in the market. The best one can do is to put aside emotion and to look at the facts. Or one better, and use emotion to your advantage by looking at sentiment, rather than having it control you. Last week’s sentiment overview was clearly the most pessimistic in a very very long time.

90-90 Day? - You Betcha! (wink)
As much as last week’s market’s were smashing all records on the way down, Monday’s rally smashed them on the way up. This was as broad based and furious a come back as the bulls could have mounted.

In terms of volume, 95% was accounted by advancing stocks on the NYSE. We went from seeing more than 2,500 stocks on the Big Board hitting new 52 week lows on Friday… to seeing less than 60 today doing the same today. So yes, today definitely met the requirements for a Lowry’s 90-90 up day - and more!. This is something that we had been waiting for because according to the research, a significant floor is created when the market has fallen significantly (90-90 down days) and then reverses with the same ferocity.

Here is a short excerpt from the research done by Paul Desmond of Lowry’s Research:

The historical record shows that 90% Downside Days do not usually occur as a single incident on the bottom day of an important market decline, but typically occur on a number of occasions throughout a major decline, often spread apart by as much as thirty trading days. For example, there were seven such days during the 1962 decline, six during 1970, fourteen during the 1973-74 bear market, two before the bottom in 1987, seven throughout the 1990 decline, and three before the lows of 1998. These 90% Downside Days are a key part of an eventual market bottom, since they show that prices are being deeply discounted, perhaps far beyond rational valuations, and that the desire to sell is being exhausted.

But, there is a second key ingredient to every major market bottom. It is essential to recognize that days of panic selling cannot, by themselves, produce a market reversal, any more than simply lowering the sale price on a house will suddenly produce an enthusiastic buyer. As the Law of Supply and Demand would emphasize, it takes strong Demand, not just a reduction in Supply, to cause prices to rise substantially. It does not matter how much prices are discounted; if investors are not attracted to buy, even at deeply depressed levels, sellers will eventually be forced to discount prices further still, until Demand is eventually rejuvenated. Thus, our 69-year record shows that declines containing two or more 90% Downside Days usually persist, on a trend basis, until investors eventually come rushing back in to snap up what they perceive to be the bargains of the decade and, in the process, produce a 90% Upside Day (in which Points Gained equal 90.0% or more of the sum of Points Gained plus Points Lost, and on which Upside Volume equals 90.0% or more of the sum of Upside plus Downside Volume). These two events – panic selling (one or more 90% Downside Days) and panic buying (a 90% Upside Day, or on rare occasions, two back-to-back 80% Upside Days) – produce very powerful probabilities that a major trend reversal has begun, and that the market’s Sweet Spot is ready to be savored.

Source: Identifying Bear Market Bottoms and New Bull Markets (Dow Awards folder)

Believe it or not, this is the second Lowry’s 90-90 up day we’ve had within 9 trading days. According to Lowry’s 90-90 up days can be spaced out as far as 30 days from each other and still be effective. And although most people keep strictly to the 90-90 definition, Lowry’s actually mentions above that 80-80 up days also qualify. So if you want to be more flexible like them, on September 18th 2008 we had a 89.5% up day which would make it three strong up days.

LIBOR & TED Spread
As I mentioned a few days back, LIBOR and the TED spread stopped going up and today they actually fell hinting that we may have seen the worst of the credit crisis. As banks start to trust one another and lend again, liquidity will flow back into the financial markets and the forced liquidation will cease. It is still too early to be complacent about this but the first signs of a return to normalcy are there.

What an inauspicious anniversary. It is a year since the Dow closed at its all time high - it is now trading down about 35% from that level. While I don’t think we are going to go straight up if things do stabilize, there is enough shrill panic out there to make me think that we should be close to a floor. If we aren’t, then all bets are off and I suggest we all flee to the hills. This isn’t based on mere “gut feeling” but on metrics and indicators that have been faithful guides historically.

So here are some observations:

Global Meltdown
There is enough pain for every single market out there. Forget banning short selling, Iceland outright suspended trading altogether. Indonesia halted trading after a 10% plunge. Russia has seen an utter collapse of their market. Same thing with China’s equity bubble. England has taken equity stakes in financial institutions while other European countries struggle to find a solution. There is a blanket of fear and panic covering the world to a degree that we haven’t seen in a very long time.

Credit Squeeze Easing
The first hints that we could finally be seeing a loosening up of the tight credit markets are here. The spread between the rate for the 2 year interest rate swaps and Treasury yields seems to have formed a double top at 167 on September 29th and October 2nd 2008. At its top, the spread was the widest since data has been collected (going back to 1988). This is a signal of easing for the LIBOR rate but the bad news is that LIBOR and TED spread haven’t responded by falling yet. But this may be the first inkling that they are about to.

Sheer Disgust & Panic
Finally, we can say that there is extremely negative sentiment out there. Both from everyday investors and traders, to newsletter editors. The option metrics are still not “cooperating” by showing extreme put buying. Which is something that I’ve mentioned before. It is still very puzzling to me. But the other traditional measures of sentiment show that the vast majority have thrown in the towel and believe that we will see further declines. From a contrarian point of view, this is a good thing. I’ll go into more detail in tomorrow’s sentiment overview.

How Bad Is It?
Things are so bad that, of the 500 stocks in the S&P 500 Index, only 6 closed trading yesterday above their 50 day moving average. And only 4.2% are trading above their long term, 200 day moving average. For the Dow, all 30 stocks are trading below both of the moving averages.
Continue reading ‘If We Aren’t Near A Bottom, Find A Cave & Buy Guns’

The TED spread is one of the most basic gauges of fear in the financial markets. TED stands for Treasury Eurodollar because originally it was calculated by taking the US 3 month treasury bill and subtracting it by the 3 month Eurodollar contract rate. Today the spread is calculated by taking the difference between the 3 month US T-bill rate and the 3 month LIBOR rate.

This is an important indicator because while US government issued fixed income is perceived to be “risk free” (or as close as you can theoretically get), LIBOR rates are commercial lending rates and are not. So therefore, the difference of the two isolates counterparty or default risk in the market at any point in time.

Of course, this is a generalized measure of counterparty risk across the financial markets and is not reflective of individual corporate bonds. Think of it as being a measure of credit risk the same way that the VIX is a measure of volatility. I can guarantee that it is one of the ingredients in the “Panic Button” indicator from SentimenTrader. That indicator by the way, has now shrunk back to less than 1 standard deviation away from its mean.

Right now the TED spread is showing enormous stress in the global financial markets:

Today it closed at 313 basis points which means that we have broken through the previous record set at the darkest hour of the 1987 “Black Monday” stock market crash (300 basis points). Ponder that for a second.

On the other side of things, in the summer of 2000 (remember those days?) the TED spread shrank to almost nil as everything was well with the world and everyone held hands singing songs of monetary bliss while basking in the sunshine of the “Goldilocks economy”.