Trader’s Narrative

Here’s this week’s sentiment overview chock full of sentimental goodness. Enjoy:

AAII
This week’s AAII sentiment survey moved the bulls and bears in different directions, albeit both by the same 2 percentage points. The bulls move up slightly to 24% and the bears fell slightly to 55%. Looking at the ratio of bulls and bears, we’re back to levels that we last saw in mid-July 2008 - not that it did the market much good back then. While it shows some real concern by the retail investor, it still doesn’t show extreme levels of fear. As well, the slight amelioration doesn’t bode well because when the survey was taken, the market was still at support.

Investors Intelligence
The newsletter editors, as measured by ChartCraft’s weekly sentiment indicator are 28.6% bullish and 45.1% bearish. That’s a move in the right direction but not enough to give any contrarian a reason for pause. The last time we saw real fear was late last year when there were the bullish camp was as small as ~20% and the bears more than half.

Conference Board Consumer Confidence
The Conference Board Consumer Confidence Index was released this week and it wasn’t pretty. We hit another low when it fell again to 25.0 - in fact, all three measures (including present situation and expectations) fell again. Consumers that described business conditions are “bad” rose to 51.1%. There was also a jump in people’s expectations of job losses - 47.3% from 36.9%.

Barron’s Confidence Index
Richard Russell introduced me to this lesser known indicator. It is a ratio of the high grade bond index and the intermediate bond index. Since it measures stress in the bond market, you won’t be surprised to learn that during this latest bear market it has fallen to an unprecedented degree. In November 2008 it fell to 45 and the latest weekly data is 51.6. To put that in perspective, during the end of the last bear market the Barron’s Confidence Index made a sloppy double bottom in the 65-70 range. A You can keep track of it online at Barron’s website or by leafing through the Market Lab section of the printed edition.

ISEE Sentiment
The call-put ratio known as the ISEE sentiment index actually went up on Friday, as the S&P 500 broke down to levels not seen since December 1996. I prefer to look at the equity only data for the ISE because it strips out the index and ETF trades. While not extremely high, the fact that it increased to 157 is a conundrum. It means that on average, the retail options trader on the ISE opened 157 calls for every 100 puts.

At first I thought that perhaps the fact that breadth has been favorable would account for this. While the large cap stocks fall, dragging the indices with them, more and more mid to small cap stocks are not making new lows. So perhaps the options data would suggest that option traders are betting on non-large cap stocks. But on the other hand, stocks have to meet certain criteria to have options and for the most part, those are larger capitalization stocks.

OEX Option Sentiment
The S&P 100 index put call option ratio is once again at a bullish extreme. Two weeks ago I mentioned that the OEX options sentiment was sliding to levels which have previously been interpreted as very bullish. This week, they continued to fall, registering the lowest daily ratio in about 25 years. While normally this would be wildly bullish, there are two problems with this.

One, the number of contracts traded in this specialized options market has been steadily eroding and it has reached a very small number. So small that it is questionable if the data holds any real value. Second, recent extremes haven’t really yielded any actionable consequences for the market. While more and more bulls pile in buying OEX calls relative to puts, the market continues to slide.

Nova Ursa Rydex Ratio
The Rydex family of funds were the first precursors to the ETF smorgasbord that we have today. Although pushed further to the periphery with each leveraged ETF, they are still around and command a significant chunk of funds under management. The Nova Ursa ratio measures how bullish or bearish the Rydex investors are feeling at any moment. The Rydex Nova returns 150% of the S&P 500 daily returns while the Ursa fund (now known as Inverse) attempts to return the opposite returns generated by the S&P 500 index.

The current level of bullishness - as measured by how much money is dedicated to Nova vs. total funds in Nova and Ursa - is at a decade low. To find a lower ratio, you’d have to go back to late 1995. The next lowest level after that was late last year (November 2008) and previous to that early 2003. This has been a wonderful signal in the past. Two things could dampen its power: one, similar to the OEX options sentiment, the level of participation in Rydex funds has waned as people move to ETFs and leveraged ETFs. Second, back in the early 1990’s we saw the extreme readings pile up in stacks, week after week, throughout 1994, until the S&P 500 index took off like a rocket in early 1995.

Far be it from me to criticize a luminary of technical analysis but it certainly appears that Richard Russell is confused.

For those who are unfamiliar with him, Richard Russell is known as the Sage of the Dow for his expertise in Dow Theory. He has been writing about the market non-stop for more than 50 years and has made some truly legendary calls.

In the past few years Russell was very bearish and recommended gold instead of equities. This changed in May 2007 when he surprised everyone by turning into a bull, saying, “an unprecedented world boom lies ahead”.

But recently Russell has changed his mind again, saying, “the long-term trendline has been violated… Until proven otherwise, the long-term trend of the Dow is now down.”

He was referring to the red support line in the chart below:

Russell drew the trend line from the low in 1982, the launchpad of the great bull market in modern history, to the low of the bear market in October 2002. Clearly, this support is now violated to the downside.

This sounds very logical but if you stay with me for a bit, I’ll explain why I have a tough time accepting it.

Let’s imagine that we have gone back in time to the desolate bear market of 2002. Prices are careening into an abyss, pessimism is so thick you can cut it with a broker’s statement.

Now, standing as we are back in 2002, we follow the same process that Russell did and draw a trend line showing the support level in the Dow Jones from the bottom of 1982, connecting it to the low in 1995 and the low created in the aftermath of the September 11th 2001 tragedy. The line would look something like the dashed purple one in the chart above.

Obviously, even if we imagine ourselves in October 2002, for the sake of this exercise, we had no way to know for sure that this was the bottom. So rather than use it as the point through which to draw the trend line, we would use the points mentioned above.

So the conclusion that we would then draw is that the long term chart of the market is broken and the trend of the Dow is down.

But that would be incorrect.

Because not only would the worst of the bear market already have been over, within a very short time a new bull market would be born.

So clearly, hunkering down into “bear market mode” at this point in time (mid to late 2002) would do us no good at all. In fact, the smartest thing would be the opposite, to have cast around for beaten down stocks to buy in anticipation of the termination of the brutal bear market that we had so far endured.

Richard Russell usually concentrates on the Dow Jones but here is the chart of the S&P 500 for good measure, showing the same thing:

In the end, I’m afraid this leaves us where we started: confused. But it is one thing to flop around randomly, switching sides as the wind blows, and quite another to confess in frank humility before the power of the market that one is confused.

In an attempt to thoroughly confuse my remaining few readers, here are two polar takes on the market:

Seasonality
The best time to be long the stock market has been from November to the end of April. The months from May to October, produce so little in returns - on average - that you would do better parking your money to earn income. This seasonal pattern is usually expressed with the rhyme: “Sell in May and go away”.

Now, this is just a historical pattern and it doesn’t perfectly play out each year. But over time this has been the average performance. So now we have seasonality working against us, rather than with us.

As well, Hulbert did a quick study showing that winter months that have produced negative returns go on to produce negative returns in the summer as well. But winter months that have produced positive returns buck the “sell in may” trend and continue the positive performance.

The only good news from the data mining is that the summer months following down winter months have much higher volatility. So for those who are equally comfortable going long and short, we may have perfect trading weather breaking on the horizon.

Oracle of Dow Theory
On the plus side, Richard Russell, is unapologetically super-bullish. Russell believes that the bull market never really left. Even the 2000-2002 bear market was just a “correction” within a continuing secular bull market that began in early 1980’s.

He bases this on two reasons: during the darkest days of the bear market in 2002, we never really got to a true bear market valuation. Two, from a technical point of view the market has been building a base.

Russell is worth listening to because he has seen decades of market history and he has studied it closely day after day. There was a time when he was a frequent writer for Barron’s. This was way back when Barron’s had a technical analysis bent, before it jumped the shark.

After Richard Russell’s recent bullish pronouncement that “an unprecedented world boom lies ahead” many - especially the permabears - have interpreted this as the last great bear throwing in the towel.

They go on to claim that this capitulation by the formerly bearish Dow Theory guru means that we are at the top and about to crash. I find this sort of thinking to be nonsense. First, the idea that the market tops when everyone is a bull is true. That’s because with everyone on one side, there’s no one to provide buying pressure to drive the market higher.

But is that the situation we have? According to sentiment the retail investor is keeping as far away from the stock market as they possibly can. Presumably they are otherwise occupied in real estate, flipping condos. And what about all the other gurus out there that are still preaching doom and gloom? that a crash is just around the next new high?

Most importantly though, those that interpret Russell’s new bullish stance as capitulation simply do not understand what he has been writing about for the past 50 years: Dow Theory.

Dow Theory is a mechanical system that, although far from perfect, leaves little room for interpretation. Simply put, when the indices are in synch and reaching new highs, Russell could not do anything but follow the clear signal and write what he did. He wasn’t capitulating to anything. He was simply following the playbook he’s been following since he became involved with the markets.

No one knows the future. Are we truly at the foot of an unprecedented global boom or are we just days away from a devastating crash? What we do know is that sentiment is decisively bearish out there and there are still plenty of naysayers that criticise and disbelieve in the performance of the markets.

Richard Russell with B-25 Mitchell Bomber in Italy (1944):

Were you watching April 20th 2007? if not, did you catch it on April 25th 2007?

I’m talking about the Dow Theory buy signals that occurred on both those days.

Richard Russell didn’t miss them. He’s dedicated his life to the study of the markets through the prism of the Dow Theory and for the past 50 years written a newsletter called the Dow Theory Letters.

Recently he wrote:

“We saw something that is extremely rare, in fact I can’t remember ever having seen this before. What I’m referring to is that on those two dates all three Dow Jones Averages Industrials, Transports and Utilities — closed at simultaneous historic highs. To me, a fellow steeped in Dow Theory for over half a century, this was like a clap of thunder… My take on the situation is that the stock market (and the Dow Theory) told us that an unprecedented world boom lies ahead.”

This is an astonishing about face since Russell has been bearish, almost non-stop, for the whole duration of this bull market!

I say almost non-stop because he has taken a few short “trading” buys here and there. But for him to finally acknowledge that this is indeed a bull market is quite remarkable. For me, it crystalizes that whatever logic you bring to bear to your analysis of the markets, ultimately, you can not argue with the most powerful element: price action.

But what I’m curious about is how Russell has resolved the primary reason why he was so bearish: valuation. As he says on his site:

All other Dow Theory considerations are secondary to the value thesis. Therefore, price action, support lines, resistance, confirmations, divergence — all are of much less importance than value considerations, although critics of the Theory seem totally unaware of that fact.

I suspect that he still doesn’t feel that the market is “cheap” but has issued this buy signal because of the undeniable price action. We should remember that the Dow Theory is not perfect. It has given wrong signals before (which theory or method hasnt’?) but you can’t deny that it is yet another vote of confidence towards this market.

Finally, I wonder what this means for the gold market. While Russell has been bearish on the market, he has been staunchly bullish on gold. I wonder if this means that he has also changed his mind about that.

Things may get interesting with the Fed meeting tomorrow. Will we have another spike up? or will it be the end of the party?

via Mark Hulbert at MarketWatch.com