Trader’s Narrative

After six trading days wound tight into a narrow trading range, the stock market finally cracked decisively and fell lower. The range, as measured by average daily true range was extremely slim at 16 points (for the S&P 500 index). The range became a razor thin 5 points when we look at the highest and lowest closes.

Of course, we’ve been anticipating this for some time now. We’ve gone over the sentiment data, the seasonality argument as well as the pattern provided by the aftermath of bear markets throughout history.

As well, it was impossible to ignore how incredibly overextended the stock market had gotten. Take for example, the breadth as measured by the percentage of stocks trading above their moving averages. For the S&P 500 index, last week, we had 91.6% above 10 day moving average, 92.6% above 50 day moving average and 94.2% above their long term, 200 day moving average.

And it wasn’t just that index. Pretty much every single proxy for the wider market was stretched to the breaking point. For example the Dow Jones had every single component trading above the 50 and 200 daily moving average. And just one stock from the Dow didn’t manage to close above its 10 day moving average.

Other measures of breadth were also unbelievably extreme. For example, at 81%, the NYSE bullish percent was higher than it had been for at least 22+ years!

Even more alarming, looking beneath the numbers, the lowest quality stocks were not only participating in the rally, they were leading the charge.

While the S&P 500 managed to peak over the June highs momentarily, its recent action is reminiscent of mid-June. Then, as now, the index managed to eek out a win over the previous swing high (in early May) and then entered a narrow range. Only to break down lower.

Another interesting observation is that while the S&P 500 index was higher in August, the number of new highs did not continue to expand. Since the spring the recovery was supportive of a higher and an increasing number of stocks were making highs but then the music stopped:

Lowry’s Intermediate Market Call
A few weeks ago I mentioned an important market call from Lowry Research. While at first Lowry’s intermediate buy signal may have sounded as if they were suggesting their clients to go wildly bullish, that wasn’t the case. They were recommending adding exposure after a correction. And that may be exactly what we are about to see unfold.

The S&P 500 has weak support just above 975 and much stronger support at 875. So those are areas to watch. As well, I’ll be looking at how fast we drop as well as looking for specific stocks that will display relative strength by bucking the general tone of the market.

Here is a recent interview with Tracy Knudson of Lowry Research in which she further explains their recent market call and delves into their analysis of the market. If you haven’t already, I suggest you listen or read Lowry’s intermediate trend buy signal first and then listen to this newer interview.

To listen, press play and then pause to allow the audio file to completely buffer, then fast forward to the 40 minute mark:

If you would like to receive a free copy of Jason Scharfman’s book, Hedge Fund Operational Due Diligence, enter the draw by leaving a brief comment at the above link (making sure you leave your correct email).

While we started to see a trickle of extreme bearish sentiment and some semblance of capitulation in last week’s sentiment overview, yesterday’s option market was shockingly and wildly bullish.

On the ISE, 201 calls were traded (to open) compared to 100 put options (equity only). Including ETF and indices options, that ratio jumps to 220. The CBOE (equity only) put call ratio fell to 0.60, almost confirming the same level of optimism. The last time the ISE sentiment index was above 200 was on the last trading day of 2008, which turned out to be a great contrarian signal:

But behind yesterday’s wildly optimistic ISE sentiment number, there’s a lot of nuance. So much in fact, that I’m afraid it leaves us with little meaning once we’ve explored it all:

For example, as I mentioned a few months ago, the ISEE index has settled into a narrow range. You can see by the yellow line in the chart above (representing the 10 day moving average) that this has for the most part continued.

You can see that in contrast to what we saw at New Year’s, the 10 day moving average is horizontal. I’m not sure what this narrow range means but it makes me uneasy to see this indicator behave so uncharacteristically to its past.

One possible reason why the options markets have been behaving so crazy is that the common stocks in the financial sector are mercilessly hammered, so the options on them become inexpensive lottery tickets. I’m not sure if there is a way to strip away option trades based on industry or sector so until then, this will remain a theory.

Another potential reason for the rare behavior of the ISE data is that more and more, traders are using leveraged ETFs to take directional bets on the market. These trading vehicles offer almost all the leverage of out-of-the-money options, without having a time value decay.

A final possible explanation is that the ISE is having some data issues. Although rare, I did catch an ISE data reporting error once before. Once again, I’ve looked over my data from them and noticed that somethings just don’t match. So I’ve emailed my contact at the exchange responsible for data integrity and hope to have this question settled at least.

Like all bear markets, it is incredibly difficult to read the cross-currents. Just staying in the game is winning at this point. Stay tuned as I’ll write an update when I clear this up with the guys over at the ISE.

As I previously touched on, we had a 90-90 down day on Jan. 4th 2008. According to the Lowry’s study, all we need now is a 90-90 up day for a market bottom.

90-90 Day
Today wasn’t it. Although the market went up, it did so lethargically. Volume did flow in the right direction: advancing stocks in the NYSE were 1,003,680,000 compared to 401,066,000 declining stocks - a 5:2 ratio. And on the Nasdaq, almost 3:1. But we need much more excitement than that to forge an inflection point.

On January 7th, the S&P 500 put in a hammer-like candle (if you squint) with normal volume as traders came back from holidays. This was two days after I wrote Rally around the corner :

And although we still haven’t taken out those lows, the market is coiling into a tight range. If it reacts to the recent oversold conditions and breaks out, then the probability of it continuing and regaining lost ground is high. But it can also break down to retest the lows. Or even go lower.

The market is. No one can predict or control it. I’ve shared a thesis of where things may be, but I’ll let the market prove me wrong or right.

Stocks vs. Bonds
Right now, by several measures, bonds are expensive and stocks are cheap. I’ll go into this point more in depth in a few days. What matters though is that this important relationship is skewed towards a rally. But this is a myopic market. The only thing it can focus on is what is immediately in front of it. Which happens to be Tuesday’s expected announcement from Citigroup (C).

Being the market tell for the day, I’d suggest keeping a watchful eye on Citi.

Here’s this week’s sentiment commentary:

Sentiment Surveys
LowRisk is showing the most positive picture with bulls falling to 29.4%. In contrast, AAII bulls are at 49% and the II bulls at 55.6%. I don’t know about you but I’ll take the latter surveys over the one exception.

It isn’t surprising to see the AAII bulls jump so high, so fast. After all, even in the darkest days of August, their pessimism was guarded. They never really got spooked. Now that the market has recovered, they’ve jumped on again. From a contrarian perspective, that doesn’t bode well for the market going forward.

Narrow Range & Low Volatility
Since I suggested to sell something, the market has entered a narrow range, meandering with no conviction. The rhythm of the markets is such that expansion tends to be followed by contraction. Just as you need to breath out, before you can breath in again.

Volatility (VIX) which spiked to 37.50 just a month ago has collapsed to less than half. That doesn’t automatically mean that the market can’t continue to climb. Remember, low volatility has no correlation to market behaviour (as opposed to volatility spikes). What it does tell us is that the low risk opportunity to buy was back then when the VIX spiked, not here — click to see a long term chart of the relative VIX index.

Magazine Cover Indicator
Here is this week’s Economist magazine. The gun has an inscription “Made in America” - implying that the credit crisis began in the US and as the trigger is being pulled, it will “trigger” a new downturn. At least, that is the question the cover is asking rhetorically.

There is no question that this cover is negative but the metaphor of a gun being pulled is a bit awkward so I’m not sure if it qualifies as one of the classic magazine cover indicators.

In any case, as a contrarian indicator, I would interpret this mildly bullish for the market and for the whole credit mess. I think the worst is behind us. The market still needs to mop up the mess and that will take time, but it doesn’t make sense to wallow in fear and loathing about something when it is on the cover of magazines and when journalists are writing related articles at the fastest clip ever.