Trader’s Narrative

Yes, today’s decline was yet again another Lowry’s 90-90 day and it took us perilously closer to the ledge. Or over the ledge, depending on which index you’re looking at and how thick you draw your support lines. Weinstein’s support level is still not breached, for whatever that’s worth. Is everything lost? I turned to an ancient way of looking at the health of a market.

You already know how to use bullish percent indices to time the stock market. Although they are usually shown in point and figure charts (those X’s and O’s), I prefer to look at a line chart because it moves in tandem with time and the market proxies like the NYSE index, Dow Jones and S&P 500.

But the original way that bullish percent charts were interpreted was to gauge where we were along a continuum of bull or bear market. The short version is that when the NYSE bullish percent index moves up above the 70% line and closed below it, the market is on notice. Similarly, when the NYSE bullish percent index moves lower than 30% and then breaks above it, there is an indication of underlying health, and a portent of a nascent bullish rally.

Looking at a very long term chart of the NYSE bullish percent index, it is easy to see the efficacy of this measure of market internal health:

Recently though, the NYSE bullish percent index has been breaking down through the 30% level not only often but to such a degree that it has fallen lower than it did after the Black Monday crash of 1987.

Here’s a chart zooming into the past two years to show more detail:

Each successive piercing of the 30% “maginot line” brings about a weaker and weaker counter rally from the market. Until in July, the market barely manages to plateau before falling again. So what’s up? Why is this once solid indicator start to sputter and fail so badly?

My hunch is that what changed over time was the inclusion of non-equity securities on the big board. Right now half of the securities traded on the NYSE are closed-end funds, ETFs, ADRs, municipal bond funds and other funny pieces of paper that do not represent fractional ownership of a public company as it used to when traders started pushing paper under the Buttonwood tree.

This is why Lowry Research service started to keep “operating company only” NYSE data. Speaking of Lowry’s, I went to a presentation by one of their analysts last night and will share the details with you tomorrow.

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.

Sentiment Surveys
According to Investor’s Intelligence newsletter publishers are as gloomy as they have ever been. This week’s sentiment bearish sentiment was 54.4% with bullish newsletter editors unchanged. While slightly more than half may not seem like much, you have to understand that like most media outlets, newsletters have a positivity bias that skews readings. But keep in mind that the II measure is not completely quantitative.

The American Association of Individual Investor’s (AAII) sentiment survey in contrast continues to show that retail investors in the US have suddenly become very bold. Similar to last week’s sentiment the optimists and pessimists are both 38.74%. This apathy or lack of fear is strange and more than a little unnerving.

Volatility
Volatility continued to climb to the astonishment of everyone (first and foremost yours truly). The CBOE VIX index spiked to 89.3 and settled down to “only” 79.1 - quick someone give me a synonym for un-fraking-believable. Looking at the VIX futures market, the “smart” money, or commercial hedgers are carrying the largest long position they have ever been since the contract started. While the retail traders are taking the other side of the trade.

Options
The options market yawned as usual. I prefer the CBOE equity only put call ratio because it filters out the noise. Although it rose, it didn’t even manage to reach 1.0 - it should easily be above 1.5 considering what we are going through. I tried to explain this crazy options market. But I’m not sure if I even convinced myself. This, like the majority of what is going on, is a head scratcher.

Fund Flows
As you can imagine, mutual funds have been hemorrhaging assets as people either sell to stuff cash under the mattress or take the slightly less safe road and buy money market funds. But preliminary numbers for the most recent fund flows shows a slight inflow. Again, this is puzzling. From a contrarian point of view, the ideal condition would be a continued outflow trend, even if the market rallied or stabilized - which it hasn’t really done.

What I’m still waiting for is the tsunami of hedge funds redemptions. Usually hedge funds have a lock up period to give the manager some breathing room. The more exclusive the hedge fund, the longer the lockup but usually it is 2-3 months.

Lowry’s 90-90 vs. Selling Pressure
As the VIX indicates this is an unbelievably volatile market. We’ve had so many 90-90 days (or very close calls) that my head is spinning. On Friday 84% of volume on the NYSE was negative. On Tuesday (October 21st) we saw almost the opposite with 87% flowing to stocks trading up.

Paul Desmond’s research at Lowry’s into the efficacy of 90-90 days has permeated the trading and investing world so much that I fear it may jump the shark. But assuming that it hasn’t already, there is more to the market than just watching for these important days. Lowry’s itself calculates two aggregate indicators for the market’s health: buying and selling pressure. Right now selling pressure has the upper hand (after jumping to an extreme level). Until it subsides and buying pressure takes over, the market isn’t going to go up.

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.

This is not meant to be alarmist message but rather to illustrate how historical bear markets have behaved and also, to balance what seems to be a far too prevalent nonchalant calm about what is going on in the markets.

Although the classic definition of a bear market is a 20% decline, there is no reason why a falling market should stop at that limit.

In fact, previous bear markets have been much more devastating. As mentioned in the most recent edition of Barron’s, out of the last 10 bull markets (from 1940 onwards), only 3 other bull markets have not erased 50% or more of the gains they provided. The average bear market has delivered a 30% decline (for the Dow).

Back in late June 2008, Paul Desmond, of Lowry’s Research was quoted in Barron’s:

“We think we’re still quite a ways from a bottom,” Desmond warns. Over the next year, he expects the Dow to fall 30% to 50% from its October ‘07 top. The market could enjoy a few short-lived rallies during that span, like the one we experienced from March through May. But each rally is apt to result in a lower high and a lower low in the market.

What would a 30% or 50% decline look like?

The S&P 500 Index (SPX) reached a top in October at 1565 and its 2002 low was 777. Which means that the bull market gained 788 points - the market doubled, in other words. But now we’ve lost ~50% of those gains.

And if we fall 50% from the October 2007 we would be slightly under where the S&P 500 Index found its bear market footing way back in early 2003. A complete round trip.

I’m not predicting that will happen - no one knows where the market will be, of course. The point is that such a scenario has happened in the past. and is far too probable than most people would imagine.