Trader’s Narrative

Today Bernanke’s testimony on Capitol Hill stoked a rally as the market interpreted him to be more dovish than previously. Specifically, he said:

We must take account of the possible future effects of previous policy actions — that is, of policy effects still in the pipeline.

This was taken to mean that Bernanke is not in a hurry to push rates to extremes in an effort to control inflation but instead is willing to take a more relaxed approach to allow the effects of previous increases work themselves through the economy.

The market may think this is bullish, but according to James Stack of InvesTech, history shows evidence to the contrary:

…in the past 80 years, there has been over a 71 percent probability that stock prices will be lower six months after the final rate hike.

In any case, the market had a fantastic trending up day. In fact, it was so bullish that again, we saw more than 10 times the volume in stocks closing up than down. I wouldn’t be surprised if it was also one of those fabled Lowry’s 90-90 days too. This sort of market action is very rare because such skewed positive days don’t usually cluster this close together (we had two other ones in the past month). But eventhough they are rare, they are unmistakably bullish.

The volatility, as measure by the VIX index, got crushed again today falling intraday almost 18% ! To be honest, I’m getting tired of this. Uncharacteristically, it has been happening a lot lately. Historically it has been bullish but the reason I don’t really like it right here is because it shows a market that is too ready to abandon its skepticism. And as you know, skepticism, like virginity, should not be abandoned too readily.

We see this same phenomena in the Hulbert Stock Newsletter Sentiment Index (HSNSI). According to Hulbert, at the end of June, when the S&P 500 was at 1270, the HSNSI stood at 12.6%. Then days later on July 12th when the S&P 500 was lower at 1258, the sentiment reading was higher at 31.4%. And the Hulbert NASDAQ Newsletter Sentiment Index went from a -25% at the end of June to 0% on July 12th, eventhough the Nasdaq fell more than 40 points. Tsk, tsk. That’s not what lasting rallies are built on.

Here’s the daily Nasdaq 100 chart :

According to the classic definition: lower lows and lower highs; we are still in a clear downtrend. We’ve just put in our third lower low in fact. And unless the previous high is taken out and a higher high put in, we can’t really claim that the trend has changed. For that to happen, we would have to see the index climb all the way to close above 1600.

Is it possible? Sure. But if the market does go up from here, you can bet that it won’t be powered by the old has beens of yesteryear: Yahoo!, eBay, Microsoft, Dell, etc.

Instead, look for tomorrows leaders to be unknown, mid-caps, in unpopular sectors and possessing the ever important, strong relative strength.

The AMEX gold bugs index has bounced back, finding support at the 280 level exactly where it did so before in March 2006. This caught me off guard since I was bearish on the sector. But there’s been a concomitant rise in bullish sentiment which does not bode well for the gold sector; atleast in the short term.

According to Mark Hulbert, the sentiment picture has changed too quickly for this bounce to have any more legs. His Hulbert Gold Newsletter Sentiment Index - a calculation of the average recommended exposure in the sector by gold timing newsletters - shows a jump of more than 70 percentage points in only nine trading sessions. This is the biggest nine day jump in many years.

With such a rush to get back into gold just as it has bounced off intermediate support, things don’t look that good. Bulls should ideally see a skepticism if this rally is to have any endurance.

As well, the k-ratio has increased to levels where gold stocks have hit resistance in the past. Here’s an explanation of the k-ratio, in case you’re not familiar with it.

One of the reasons why I was bearish on the sector was breadth. At that time, the % of gold stocks above their long term moving average was still quite high. But immediately after I wrote that, that percentage fell very quickly from 75% to 20%. This breadth washout was so rapid it took me by surprise. So it was understandable that with such a dramatic deterioration in breadth and with gold itself kissing its 200 day moving average we would see a swing bottom in the middle of June.

But similar to the sentiment picture, this metric has turned around just as quickly as it fell. Now just a few trading days after, we again see the breadth showing 100% of stocks above their 200 moving average. The probability of a rally continuing with such an overstretched breadth is extremely low.

In fact, the probability is that we’ll see either a pause here or a retrace. If HUI does fall from these levels, it could carve out an almost perfect head and shoulders with the 280 level being the neckline:

On June 15th, the VIX fell almost 26% (green arrow). And as I’ve already mentioned before, whenever the volatility index falls more than 10% in a day, historically, the following 10 trading days the market is higher.

The day after volatility was crushed, the S&P 500 opened at 1256.16. Ten trading days later on June 29th, the index was at 1272.87 - 16.71 points higher. This was in keeping with the historical pattern of this signal and was a welcome result since last time things did not work out as well.

But there are two things that you have to keep in mind. One, there was a negative incursion of 19 points before the 16.71 point advance. And two, it is questionable if we would have been a positive result without Thursday’s Fed announcement bull rampage.

Since I’m not a systematic trader, I only offer this concept as a backdrop. But if you are a systematic trader, the fact that most of this higher close came about as a result of one day and a very rare day, wouldn’t matter. At the same time, I don’t think any good system would risk 19 points to gain 17 points.

Interestingly enough, on June 29th the VIX again fell more than 10% - about 17.5% (purple arrow). So I’ll revisit this again in about 10 trading days to see how the latest signal worked out.

For more on the change (rather than absolute reading) of the volatility index and its interplay with the market, check out this recent article from Mark Hulbert.