Trader’s Narrative

So was that capitulation? I don’t mean today’s gangbusters market. I mean yesterday’s rollercoaster ride.

Let’s see…

Stop, Hammer Time!
The intraday reversal gave us a beautiful, textbook hammer candlestick. Using the traditional Japanese candlestick theory, after a downtrend this is a portent of the end of selling pressure. Although the low could be tested - especially with Friday’s gap - a hammer is a bull’s friend.

Market Internals
The market was deeply oversold. The NYSE cumulative intraday TICK reached levels only seen right after September 11, 2001 and during the bear market bottom in the summer of 2002.

The New High Lows Index for Nasdaq reached 2.29%. Simply put, almost no highs, and almost all lows. To find a more extreme reading, we’d have to go back to the fall of 1998. Which as you know was a major market bottom.

Only 9.4% of the stocks in the S&P 500 index closed above their 50 day moving average. And only 34% above their 200 day moving average. The NYSE McClellan Summation index got as low as it has been since the bear market bottom.

My Kingdom For T-Bills
During Thursday’s nail biter of a session there was an exodus from anything risky towards the least risky asset. Theoretically risk free Treasury Bills. The run on government paper pushed the yield down to 3.86% for 3 month bills. To make things worse, due to an unexpected rise in tax receipts the government issued less paper. This sudden imbalance is extremely rare. And it only happens during panics (which… say it with me now… form bottoms).

I felt uncomfortable agreeing with Cramer, but I think this is one of the reasons why the Fed acted this morning. Commercial paper was being shunned. They stood up and basically told the market We got your back. For a bit it was touch and go, but my world feels right as rain again.

Margin Bulletin
I got a message from my broker warning me that positions in VIX futures and futures spreads could face an increase in margin from the CFE. I’m thankful for the headsup but I don’t trade these securities. I did notice that margin tweaking is a sign of inflection points. Just something to tuck under the hat.

Retail & Institutional Fund Flows
This is fascinating. According to the estimates from TrimTabs, we just had the highest weekly outflow since right after September 11, 2001. For about two years now the US mutual fund investor has been shunning the US stock market. But this week they pulled $12.8 billion out of US equity mutual funds.

According to TrimTabs, since the beginning of year, mutual fund buyers have been net sellers of stocks resulting in outflows of $35 billion in the last 4 months. The only time we saw similar outflows of this magnitude was during June 2002 and September 2002. You know what that was, right?

Strangely enough, bonds are the most popular asset class along with money market funds. They are even more loved than international markets. Bonds have seen an estimated $92 billion inflow since beginning of year this year.

That’s the retail side. What about the institutional mutual fund asset allocators? I’ll give you one guess.

They’ve been diving into the US market with the same intensity as the retail side has been escaping from it. So the smart money is buying and the emotional, dumb money is selling. Watch the video for more details:

Commitment of Traders
The most recent COT report dovetails with the fund flows data. We are seeing a continuation of the commercials going huge net long and the small speculator going the other way. Whether the futures market or the stock market, the two sides have clearly outlined their positions. There is no doubt where they stand.

What, Me Worry?
Which gives me a possible explanation for the sentiment picture. Perhaps the reason we are not seeing a total all out panic and despair from the retail investors during this downturn is that they simply don’t have any real vested interest in the outcome.

If we go by the COT and fund flows, they have very very few chips on the table. So why would they care? why would they get scared? Most of their money is squirreled away in cash equivalent and bonds and international markets. Unlike the 2000 top, they have very little invested in the US. Why would they even really care if the US market ticks up or down a few percentage points?

A few weeks ago Maoxian was going over his call in mid September 2006 to lighten up on the energy sector. As it turned out, that was the time to actually put money to work. I piped in saying that if you were watching the bullish percent chart for the sector, you would have noticed that it was very oversold (at around 20-30%).

In case you missed it, earlier I went over how you can use the bullish percent indicator to time the market.

In any case, the Chairman brought up a great point in reply: that bullish percent charts can misguide at times of major trend change. As I mentioned before, a bullish percent chart can go all the way from 0% - that is, no component of the index being in a point and figure buy formation; to 100% with all of them being in bullish formation. So eventhough we key off specific extremes like 20-30% for lows (bottoms) and 70-80% for highs (tops) there is no reason why the indicator has to bounce off those levels. Or any reason why it can’t simply sit at a level and remain there for as long as it wants to.

S&P 500 Energy Sector Bullish Percent Index (1999-2002)

Looking back through time, sure enough, we find examples where the bullish percent chart of the energy sector did fall below the 20% level. In fact, in July 2001 it fell to 10.53% and in the aftermath of September 11, 2001 it fell to an unheard of 3.80% !! Within a year, it was back at those “unheard of” levels: 6.58% (July 2002).

So we obviously can’t just push “BUY” when it hits 20%. I don’t think you should consider any indicator, no matter how great its historical performance, in isolation and let it dictate your trading decisions by itself. Although it makes matters more complex, we increase the chances of success by layering several indicators on top of each other and only going long/short when there is maximum agreement among them.

But assuming that you had gone long on a signal (at the 20% level) as a trader you would only have lost as much as your stop loss. You do have a stop loss, right? In late July 2001, when the energy bullish percent index and the sector itself continued lower you would have had a logical rethink. Your losses in that case would have been quite limited.

In the broader market, in recent years the Nasdaq (COMPQ) bullish percent’s “low” extreme has usually been around 35% while in the years 1999-2002 it’s low was 20%-25%. This isn’t surprising when you consider that recently we have been in a bull market, while back then we were in a bear market. In a bull market, we are apt to see more shallow pullbacks and to see the indicator spending much longer meandering in the higher ranges as overbought leads to more overbought. So you shouldn’t treat the bullish percent levels as absolute, but rather as guidelines which give a feel for how overbought or oversold the market is.

Nasdaq Composite Bullish Percent Index (1999 - 2002)

The most important point I can leave you with is that in order to get the most out of the bullish percent indicator, we must first recognize whether we are in a bull market or a bear market. That may seem to be a tall order but with a few tricks, tips and indicators it isn’t that difficult. Of course, nothing is guaranteed but being on the right side of the market isn’t as impossible as economists and EMH theorists would lead you to believe.

There is especially one little known indicator which has an uncanny ability to point out the genesis of bull markets. Care to guess which it is? I’ll cover it in a little while if you can’t anyway (hint: it starts with a “C”)