Trader’s Narrative

Well, that was something. Wasn’t it?

Simply breathtaking.

I love it when things align like that. I had to take care of some things yesterday or you would have found me gloating about this much earlier

An old saying around Wall Street is that the market moves to exert maximum pain to the maximum number of participants. If this isn’t what just happened, I don’t know what is. Who in their right mind could have foreseen what happened this week? the breakout? the sheer intensity and unrelenting buying pressure?

Unfortunately for them, those that bear the brunt of the damage tend to be the outsiders, the unwashed masses, otherwise known as retail investors and traders. For the most part, insiders make out just fine.

Speaking of insiders, the latest Commitment of Traders report, hot off the presses, shows a continuation of the same lopsided buying from the commercials. Brace yourself, because since the last report, commercials have increased their aggregate net long position by 36%.

Eventhough I was bullish as I outlined this past week, I was still taken aback by the force of the bulls. They simply demolished the bears. I don’t care what thesis a bear trots out: inflation, the dollar, China, etc… it is all meaningless in the face of such a clear and powerful breakout.

What’s more fascinating is that according to the Hulbert sentiment measures, newsletter publishers are not at all excited about the market… even as it has gone up. In fact, in the face of a rising market, sentiment has actually become less bullish. To be specific, in late February 2007, when the market was going strong (before the correction), bullish sentiment as measured by Hulbert, was 62.4%. Since then, the market has recovered the correction and then some. But newsletter bullish sentiment is now 40.6%

And Thursday’s rocket ride did not make one iota of difference! It seems like the newsletter writers out there are scoffing at the price action as merely a mirage. Who knows, it may very well be. But with history as a guide, we know that the probability of it being real is high when there isn’t much excitement accompanying market gains.

But (there’s always a but) the Investor’s Intelligence report on newletter sentiment shows a completely different picture. According to II there are 21.3% bears and 49.5% bulls. That is a fairly toxic ratio of bulls to bears. But if we look back to 2003 we see that after the bear market low was made, and as the market rallied almost continuously for the whole year, the sentiment was equally bearish according to II. So maybe history will repeat. But why are the sentiment measures so at odds?

I believe it is because Michael Burke and his team over at II use a different method to categorize newsletters. Rather than going by what the newsletters are recommending (which Hulbert does), they go by their feel of the bullishness or bearishness (or neutralness) of the newsletter after a reading. This is a much more subjective method and may account for the variance between the two sentiment measures. Ideally, we would like to see them agree with each other. But we can’t have everything now, can we?

The last time I touched on the odd lot data, it was in neutral territory. But in only a week, it has spiked to an extreme which has historically been very bullish.

Odd lots are transactions in the stock market which are for less than 100 shares. Since this size of transaction is characterized by retail and small traders or investors who are uninformed about the market, it is considered a contrarian indicator. So the more odd lot purchases are made, the more we would expect the market to be topping and the less purchases, the more probability of a meaningful bottom in stock prices.

We can actually gauge the involvement of retail (or “dumb money”) participants in the market by looking at not only odd lot purchases but also odd lot short sales. They should present mirror opposites of each other and usually do.

Odd lot indicators are very fast moving though, so we are looking for a short term bounce here. They are not indicative of a intermediate or long term bottom, unless they come in a herd (rather than a single spike).

That’s what happened recently. In late February to mid March 2007 the odd lot purchases spiked 5 times to bullish extremes. The amateur investors and traders wanted no part of this market (on the long side). No wonder then that we had a significant market bottom form.

The same situation played out in the odd lot short sales where during the same time period there were 4 spikes into extreme bullish levels. Amateurs were falling over themselves trying to short the market (profit from a fall in prices).

Right now though, we have just had one penetration from both odd lot purchases and odd lot short sales into bullish territory. To me that is commensurate with a kick higher going forward - we already saw the beginning of a rally from today’s strong close when the market ended at the day’s high.

Unless we see several spikes in odd lot data, I would only look for a short term but lively rally. Stay tuned for more spikes! And if you know any amateurs out there, inquire politely whether they are buying or selling.

And when they ask why you ask, be polite and say, “Oh, just making conversation.”