Trader’s Narrative

As promised in last week’s sentiment overview, here is the information and chart on the position of the retail futures traders (known as small speculators).

The most recent Commitments of Traders report covers the position of futures market participants as of last Tuesday (February 5th, 2008) and it shows that on aggregate, the small speculators are very pessimistic about the stock market.

According to data from SentimenTrader.com, the small speculators are holding just slightly above $8 billion worth of futures contracts (S&P 500, Dow Jones & Nasdaq 100):

As you can see on the chart above, this is lower than any time in the past few years. The only caveat I would throw into this wildly bullish scenario is that each time the retail futures traders throw in the proverbial towel, they do so at a slightly lower level.

The only exception to this was the low in late 2006 which was around $14 billion - above the 2003 low. And the low in 2007 which doesn’t correspond to a rally.

But after all is said and done, when we put this together with the horrible sentiment we’ve seen in the past few weeks, we get a picture of a market that is positioning for a bottom.

Looking at the percentage of stocks above their 50 day moving average is a quick and dirty way to find out where the market stands in the medium to short term. Looking at the percentage above 200 day moving average provides a much broader perspective.

Line In The Sand
The 200 day moving average is like the proverbial “line in the sand”. If a stock can’t hold above it, technically speaking, things are really rotten. But while that may be negative for one individual stock, when as a whole the market crosses that threshold, it usually is a sign that things have reached an extreme and are about to return to normal.

Right now, the percentage of stocks above their long term moving average are at levels which in the past have seen a resumption of the bull market. The index that got the most oversold was the Nasdaq Composite (COMPQ) which reached 34%. The next one was the S&P 500 (SPX) which got as low as 43%.

Large Cap vs. Small Cap
But there is an obvious dichotomy. Whereas the broad indices (containing a mix of small caps and large caps) show an extreme low reading for this indicator, the large caps are almost unscathed. The Nasdaq 100 (NDX) index, for example, has 60% of stocks above their 200 day moving average while the S&P 100 (OEX) has 62%.

This is no surprise since we all know that the small caps have gotten crushed in this correction. A cursory look at the Russell 2000 (RUT) shows it correcting about 12% (from recent high to recent low) - almost double that of the large caps.

Unless for some reason you believe that we are heading into a new bear market, this is as bad as it is going to get. I reiterate that this is a buying opportunity if you have a medium to longish time horizon. Especially the financial sector.

Here’s the chart for the NYSE and the S&P 500. Notice the difference between a bear market bottom and bull market inflection points:

When I mentioned the bubblicious state of the Chinese market I trotted out the factoids that their indices are trading at astronomical levels relative to their respective long term moving averages (200 day).

But this sort of tell is not very reliable. For one, tops are, by their very nature, notoriously difficult to pinpoint. Unlike their counterparts, they are not borne from meteoric flashes of panic and fear. Instead, they can just peter out slowly over time.

And for another, eventhough an index can seem to be levitating dangerously above its 200 day moving average, that moving average can be hurtling up as fast to reach it. Although seemingly precarious and unstable, it can go on and on. The same way a basketball just keeps going around and around the rim and only just as everyone is tired of watching, falls into the basket.

Here are the historic extremes of indices above and below their 200 day moving average:

Nasdaq 100 Index

• in March 2000 the index was +58% above its 200 day moving average
• in April 2001 it plumbed the depth of -53% below its 200 day moving average

We all know the famous bubble top occured in March 2000. In April 2001, the market bounced from a very oversold level but only momentarily. It soon rolled over into another down leg.

S&P 500 Index

• in October 1982 it hit a maximum of +21% above its 200 day moving average
• in September 1974 it hit its minimum of -28% below its 200 day moving average

The October 1982 instance is a good example of the moving averages moving higher and catching up to the index, and reducing the extreme distance to a normal one. The SPX continued to move higher (this was the end of the bear market of the 1970’s and the start of the next major bull market).

Dow Jones Industrial

• in July 1933 the Dow reached +50% above its 200 day moving average
• in July 1932 the Dow hit its minimum of -39% below its 200 day moving average

The historic reading of oversold in July 1932 corresponds with the bottom of the great bear market of that time. And the reverse, the July 1933 reading was met with mostly range bound trading as the index slowly resumed its advance and continued to lift off the bear market low’s of the previous year.

For the historical data, I’m indebted to Jason Goepfert, from SentimenTrader.com