Trader’s Narrative

Volatility, as measured by the VIX index, fell by almost 18% on July 19th 2006. Since historically a drop of 10% or more has been a bullish harbinger I’m keeping track of the performance of these signals. Here is this latest signal:

Following the signal day, on July 20th, the S&P 500 opened at 1259.81. Ten trading days later it was at 1278.55 - that’s almost 19 points higher. But notice that there was a negative incursion of appx. 21 points before it closed higher.

These sort of signals don’t happen very often. But lately we’ve seen quite a few of them as the VIX - and the market - has been zig-zagging up and down. I don’t use such signals as a mechanical system but instead as just another metric to get a better idea of the current market cross currents. Right now the sum of the parts seem to be continuing to point to a significant intermediate market bottom.

John, from Tale of the Tape, asks a very interesting question regarding the nature of sentiment during a bear market. He wonders whether high bearish sentiment is a bullish signal during both bear and bull markets.

Well, lets examine the bear market that began in early 2000 by looking at the S&P 500 index and the absolute readings of AAII bearish sentiment that accompanied it:

Now, be mindful that the dates for the survey and the weekly candles don’t match exactly. What I’ve done is to round ahead to the next candle/week. So for example, if the survey date is May 12th and there are two candles with start dates May 8th and May 15th, I put the “sentiment” dot on May 15th’s candle. Capisce? The result is that in some instances it may appear that sentiment was ‘off’ or ‘late’ in signalling a rally… where it wasn’t really.

Some observations from this first phase of the bear market:

• first heavy bearish sentiment was waay off for the S&P (much better for Nasdaq)
• ditto for the lighter one that came right after it
• sentiment didn’t get bearish again for a long time
• but when it did, it was a great signal for a rally in March 2001
• in early stages of a cyclical bear market, sentiment can be a great tell
• but only after the market has seen a significant decline and/or correction

And the next phase of the bear from 2002 onward:

Wow! The graph lights up like a Christmas tree:

bearish sentiment went haywire approaching 1000 - right at previous support
• naturally, a lot of people became bearish as the index revisited its lows
• bearish sentiment accompanied the index’s plunge!
• clusters of major bearish sentiment can actually be dangerous!
• it is much better to get a lone ‘dot’ than a crowd of them (see first graph)
• you need severe and sustained bearish sentiment for a significant bottom
• bearish sentiment can ‘wash out’ - no real bearish reading after March 13, 2003

But remember that sentiment, especially only one measure of it such as AAII, should never be used as a tell in isolation. Sentiment as a contrarian measure is useful, but it must be combined with other tools to round out a picture.

Today the members of AAII responded to their weekly sentiment survey with a very lopsided expectation for the next 6 months: 58% bears, 24% bulls and the rest neutral. Interestingly enough, this level of bearishness was registered after the strong close on Wednesday. So maybe people are wising up to these one day spikes, or else, they are truly very pessimistic.

The bull ratio (calculated by dividing the bulls by the sum of the bears and bulls) was last seen at these levels in early April 2005 and in mid February 2003. To find this same level of absolute bearishness (58%), you would have to go back to early 2003 :

In mid February of 2003, we saw a reading of almost 58% bears but it wasn’t until later in March that a definitive bottom was put in and a new cyclical bull born. The March 2003 bottom was put in with a 51.4% bear reading and the bull ratio was at 0.40 - higher than it is now.

The next time that AAII bearishness approached 58%, believe it or not, was way back in October 1990 :

Unlike the 2003 scenario, from August 1990 to the end of October 1990, there was an almost uninterrupted string of bearish readings above 50%. But similar to 2003, there was a dip back to retest the bottom (purple circle) in early 1991 and then the market zoomed ahead.