Trader’s Narrative

The last time I revisited the Chinese stock market, it was in the throes of a major bear market. Fast forwarding to now shows things have only intensified with the Shanghai composite trading at less than half of its top in October 2007:

While we quibble about a percentage point here and there to see if our market decline fits into the classic definition of a bear market, there are no qualms regarding that in China.

Support?
The scary thing is that even after falling so much, the index is still far from major support areas. If you look at the link above, you’ll see a long term chart of the Shanghai composite going back to its founding. According to that chart, significant support is somewhere in the vicinity of the 2000 level. That would put a potential fall to almost 70%!

I have no idea if that will happen but the Chinese stock market certainly has precedent. It is not for the faint of heart. The Shanghai Composite can go ballistic: rising as it going ten fold in the span of a year (1991-1992) but it can also lapse into deep stagnation, as it did from 2000 to 2007, treading sideways.

Dire Portents
But what interests me more is the portent of such a dramatic decline for the price of crude oil. From what I read, China holds significant responsibility for the current price of oil because of its voracious appetite. But if the stock market is a forward discounting mechanism, that means that the Chinese economy is about to decelerate or even go into a tailspin.

The corollary of that is lower demand for oil and, if I remember Economics 101 correctly, that would mean a lower oil price - all things being equal.

While scanning the sentiment landscape, I noticed something quite extraordinary.

The latest AAII sentiment measure is showing 54% of respondents as being bearish. By itself, that’s not unusual since we’ve seen numbers like it before. What makes this bearish sentiment historic is that:

1. it is very bearish (significantly so)
2. it follows a rise, not a fall in the stock market

Never in the 20 year history of the AAII have we seen such a rise in bearishness coupled with a rising market.

Let me say that again, this has never happened. Whenever we’ve seen such extreme bearishness it has been after a significant market decline and has actually been a reliable signal of the formation of a bottom.

Yet, here we are. The latest survey shows almost 2 times more bears than bulls - after the market has rocketed higher almost everyday.

What does it mean?
Unless this is some calculation or reporting error on the part of the AAII it means that the retail, Mom’n'Pop investor is spooked by the recent rise in the market. They don’t trust it. They think it is fake. They think the market will actually fall. During the March 2007 market decline they were nervous but not this nervous! At the bottom of the March decline, they were 45% bearish. Now, even after a breathtaking market recovery, even after new highs, they are 9% points more nervous.

What implications does it have?
From a contrarian point of view, this may seem automatically to have bullish implications. But if people start to act on this bearish feeling by taking money out of the market… selling mutual funds, selling stocks, etc. then it may in fact be bearish. As long as they remain as “smart” unbelievers, on the sideline, this would be bullish.

The level of caution everywhere is rising faster than the stock market. I’ve noticed it on blogs (cough), newsletters, columnists, etc. As the Wall Street saying goes, bull markets climb a wall of worry. Right now, you can have your pick: inverted yield curve, dollar, GDP, stagflation, unemployment numbers, etc… The bears are great at creating laundry lists of such reasons.

Maximum Pain
But if something is obvious to everyone, then it doesn’t matter. The market behaves in such a way so as to inflict maximum damage to the maximum number of portfolios. Its job is to kick you off. Your job is to stay in and ride the trend.

This latest AAII sentiment number is certainly a curve ball. Should we take it at face value? or try to out smart it?

Whatever happens, it is exciting to live a never before seen moment in market history.

As Spock would say, Fascinating.

On a different note, I’ve continued to add articles, books and other choice trading related resources to my box.net widget. Make sure to check it out and let me know if you have any special requests.