Trader’s Narrative

Wednesday’s market performance took us down to a seldom seen place: only 10% of S&P 500 Index components closed above their 10 day moving average.

Chart from indexindicators.com

That is oversold but according to Lowry’s research, when the market reaches below 10% for this indicator, we have a setup for a powerful snap back rally that most of the time transforms into a full blown bull market rally.

The good news is that the S&P 500 Index (SPX) is approximately 60 points above its March levels here while it has pushed the percentage of stocks above their short term average to these low numbers. The bad news is that technically, we didn’t go below 10% but actually reached 10.2% and recovered.

Here is this week’s sentiment summary:

Insider Selling
The bad news is that according to Argus Research, insiders selling pressure is now double what it was during the bottom in March. The good news is that it is still low enough to mean that insiders do not view the ensuing bounce as just a bear market rally. That gives you an idea of just how critical the March 2008 bottom was!

In mid-March, just as the market was trying to find footing, the sell to buy ratio hit 1:1. This is very rare since the long term average is just a tad above 2:1, meaning on a given week insiders sell 2 times as many shares as they buy. The last time this ratio was lower was in October 2002 when it reached 0.89:1.

Even better news, according to new research the “normal” level of selling to buying has been reset much higher due to the increasing allocation of ESOP as compensation for executives. Check out the book by Prof. Nejat Seyhun (University of Michigan) “Investment Intelligence from Insider Trading” for more.

Sentiment Surveys
There were no significant changes in the usual sentiment surveys I follow, namely AAII and Investor’s Intelligence, as bulls continue to outnumber the bears.

Investor’s Intelligence had 47.3% bulls and 30.8% bears while AAII had a similarly slight increase from 45% bulls to 46%. While optimism has the majority it isn’t anywhere near levels correspondent with major market tops.

ISEE Sentiment
This is rather odd. Usually when the market receives the kind of drubbing it got this week, option traders hurry to buy downside protection. But the reverse happened according to the ISE options data. The All Securities ISEE Sentiment Index actually went up from 117 to 140 on Friday.

This means that there were 140 calls bought (to open) for every put on the ISE platform. This isn’t the highest levels of optimism by any means. On October 8th it reached 187 and October 29th 192. But it isn’t just the absolute level of call to put buying that surprises me, it is the fact that it follows on a really bad week for the markets.

I’ve been cautious since mid April as indicator after indicator lined up against a strong continued rally. That caution seems to have been warranted as we’ve given up all the gains since. This latest ISEE data point is just one more that should keep any contrarian on guard.

CBOE Equity Only Put Call Ratio
In contrast to the ISEE Sentiment data, the CBOE equities only put call ratio went up during the week. Since it is the inverse with calls being the denominator of the ratio, this means that option traders, as measured by the CBOE became actually more cautious as the market fell.

A big question on a lot of minds is whether what we are seeing is just the run-of-the-mill bear market reaction (a bear market rally or “dead cat bounce”) or whether perhaps this is the start of a brand new bull market.

While I do have some ideas, I’m not sure myself. Well, no one really knows. What I mean to say is that I don’t have a strong conviction one way or the other right now. But I’d like to change that. So this week I’m going to cover the 7 prerequisites for a new bull market as set out by Jim Stack, the writer of the InvesTech newsletter.

According to Stack, there are seven major conditions that have historically been present before we’ve launched into a secular bull market. Like most approaches to the market, these seven conditions simply allow for a list that we can check off. The more conditions are present, the better the chances that this rally is the real deal. But as always, never a guarantee in sight!

The first one I want to cover is consumer confidence, or more precisely, a plunge of at least 34 points in the Consumer Confidence Index:

Plunge in Consumer Confidence - Marked by a drop of 35 points or more. This index is reported monthly by The Conference Board and is based on a representative sampling of 5,000 US households. It’s calculated as a weighted average composed of 40% current and 60% future expectations and is commonly used to predict the future health of the US economy. For investors, it can also provide a valuable clue to identifying the “Best Buy” opportunities on Wall Street. Logically, such opportunities seldom occur in the late stages of a bull market when consumer optimism is already frolicking at lofty levels. Instead, the time to start shopping for stock market bargains is after confidence has plummeted and gloom is widespread. In each of the past 5 recessions, the Conference Board’s Consumer Confidence Index has tumbled over 34 points before a new bull market was born. Watch for a similar drop that might help to confirm the next true low-risk buying opportunity.

Here is a chart of this indicator showing a plunge of almost 50 points:

Incidentally, it is almost at the exact same level when the stock market reached its bottom in March 2003.

Here is the other widely followed consumer sentiment survey, Reuters/Michigan:

Its good to see these two surveys agree with each other so much. The Reuters/University of Michigan sentiment survey is even lower than where it was at the March 2003 market bottom. It is plumbing depths not seen since the early 1990’s and 1980’s. Curiously, back in the 1980’s, the unemployment rate was twice as high as it is now.

Anyone familiar with market history will recognize those time periods as excellent times to buy. If you’re not or if you would like a refresher, just pull up a really long term chart from your favorite charting platform.

So we can comfortably check off this condition as being met. The next one tomorrow.

Oh and in the meantime, I highly recommend you give InvesTech a look see - and no, I am not affiliated with it nor do I receive any compensation if you do.