Trader’s Narrative

Let’s take a look back at my previous commentary on Canadian REITs’ oversold condition on June 27th, 2007. Yup, it is report card time!

Unlike many other trading bloggers who let previous calls drift into the ether I like to keep myself honest by reviewing past calls and analysis. Both to be transparent and to give myself and others another chance to learn (from my mistakes).

…we could be seeing a major trend change with REITs. But even so, they aren’t going to go straight down. I think this technical oversold picture in the short term is still actionable.

So how did I do?
My thesis was that it was yet another correction within a long term uptrend. I was right about an “actionable” short term oversold condition because we did see REITs bounce into July. However, the index failed to ricochet off its 200 day moving average as it had so many times before. So I was wrong in the sense of not seeing a trend shift taking place right under my nose.

Thinking back, I don’t think I did anything necessarily wrong. I prefer to be proven wrong by price action than trying to simply ‘guess’. I think it is always wiser to continue to do what has worked, until it proves you wrong. As long as you are practicing smart money management you’ll be ahead.

Weinstein’s Stage Analysis
If you’re not familiar with Stan Weinstein, what are you doing still reading this? Go and buy his classic book on technical analysis (on your left). Then you’ll have a great grasp of basic TA and understand what follows.

According to Weinstein, stocks follow 4 stages. From his definition, last summer the Canadian REIT sector had all the indications of Stage 3 - topping. It is now in Stage 4 - decline. Simple to see that in the chart: lower highs and lower lows.

As well, in mid-July 2007, the Canadian REIT index’s 200 day moving average plateaued. No surprise really since the index had been going downhill since late February 2007 (red arrow).

It isn’t just coincidence that since that same point in time, the Canadian REIT index has been trading consistently below its long term moving average. Something that it hasn’t done in years. This definitely denotes a major shift in REITs.

Way before they actually did, I correctly surmised that the Fed was going to have to start cutting rates. But my misstep was in not realizing that there were greater forces at play. So much so that a major campaign of tax cuts has not been able to withstand the tsunami of the credit crisis.

On a positive note, the index seems to have found footing recently along with the rest of the market, lifting off from a double bottom formation. If it continues to rise, its next challenge will be meeting the long term moving average from below as it is hurtling down towards it.

I find myself unable to resist the temptation of picking up some Charter REIT (CRH.un); a tiny real estate investment trust that has a 15% yield. Other than that I’m just going to hang on to my long term holdings.

Lesson learned:
When Sam Zell sells, real estate has peaked.

I have a nagging feeling this week will be one to remember. Whether it will be the bulls or the bears that will look on it fondly, only time knows. Here is this week’s unforgettable sentiment recap:

Sentiment Surveys
According to the Investor’s Intelligence survey of newsletter editors, we already had a dearth of bullishness, but now we have historically low numbers: 31.1% to be precise. Since stock newsletter editors are usually an upbeat lot, this is actually the lowest since October 2002 and early 1995.

Not to be outdone, the AAII survey of retail investors is showing that this week, 59% of respondents are bearish. We’ve been here before; at the beginning of the year. Lets see if this time we can light a flame under this rocket.

CBOE Put Call Ratio
Although the VIX rose moderately, thanks to the panic caused by the Bear Stearns (BSC) debacle, the CBOE (equity only) put call ratio zoomed above 1.16 - and I thought last week’s four year high was special!

Hulbert Stock Newsletter Sentiment Index
Mark Hulbert tracks newsletters in general but he also has a sentiment measure based on a sub-set of stock newsletters which time the market. This HSNSI is usually a fantastic contrarian indicator since editors tend to en masse, lose all hope when the market is carving out a bottom. And they tend to be euphoric when the market is about to have the rug pulled from under it.

Although this sentiment measure has been negative for some time, it is now showing real fear. This week it reached -22.5% which means that the average timer is recommending their clients short this market with more than a fifth of their money.

The really bullish significance of this is that in contrast to now, the last time the market was at these levels in mid January, the market timing newsletters were quite nonchalantly looking over the precipice. The fact that they have now soiled their pants (sentiment wise) provides us with a higher probability that the double bottom will hold.

To find a lower sentiment reading from the Hulbert newsletter sentiment index, we’d have to go back all the way to 2005. More specifically, to early May and mid October, 2005 when the market made two important lows:

“Dumb” vs. “Smart” Money
These are two proprietary indicators from Jason Goepfert that amalgamate several sentiment and technical indicators. The “Dumb Money” indicator fell on Friday to 12.5% which means that to find it a friend, we would have to travel all the way back to early 1995 and August 1998. You remember the summer of 1998, right? when we were suffering through the Asian currency and LTCM crisis? …good times, good times.

According to Jason, the gap between the two indicators is also as wide as it has been since 1995 and 1998. Pull up some long term charts and you’ll see the significance of that.

Consumer Sentiment
Although it would usually make big headlines, the results of the Reuters/University of Michigan Surveys of Consumers got buried amid the panic over Bear Stearns today. Consumer sentiment continued to decline to 70.5 - that’s the lowest reading in 16 years!

Like most sentiment measures, this one should also be taken with a spoonful of contrarianism: up is down, down is up. Which means that when consumers are most pessimistic, we have the best opportunity to go long. And when consumers are on average jumping for joy, we have to batten down the hatches.

News Headlines & Covers
Getting your umbrella out will do you no good. We have a torrential downpour of negative news and depressing headlines. To see what I mean, open any news website or newspaper. It is all doom and gloom. This or that hedge fund going belly-up, Bear Stearns pushing up the daisies, the mortgage market collapsing, the credit market in a spasms, consumer sentiment tunneling into the substrata, etc.

Even after the remarkable 90-90 up day we had on Tuesday, the majority are denying that it could potentially have any real bullish portent - although historical precedent says otherwise.

Here are a few recent covers from Business Week:

Double Bottom Thesis
One of the technical patterns everyone has been watching for during the recent market action is one of the most common and well known ones: double bottoms.

Thanks to yesterday’s rocket ride, it looks like this pattern now has a chance. What we need to look for next is that the low isn’t violated (obviously!) and two, that we can successfully take out the resistance levels just underneath 1400 on the S&P 500 index.

Lowry’s 90-90 Day
Everybody is emailing me asking if Tuesday was one of those famous Lowry’s 90-90 up days. I don’t have confirmation from the keeper of this measure but I’m 90% (no pun intended) sure that it was indeed a 90-90 day. It certainly looks like the market is getting ready for a running of the bulls.

In case you’re unfamiliar with the nomenclature, a 90-90 day is when we have such a lopsided day in the markets that 90% of the volume and 90% of the points are on the same side (either up or down). Research by Lowry’s has shown that historically, important market inflection points are preceded by extreme crowding to one side, then the other. If you’d like to read the original version (and save $10) download the research paper from my free trading resource section.

The best scenario for the bulls would be another extremely strong day which would be as or even more lopsided than yesterday’s. If we get that within a reasonable time, like a week or two, the chances of a solid bottom increases exponentially.

Sentiment
Yes, I know I’ve been harping on this for a while now but until recently we hadn’t really seen any truly extreme readings in the usual sentiment measures. Sure, they were gloomy but now we’re finally seeing some bearishness of epic proportions. This is a vital element, as the market approached the January 2008 lows, to determine if we are going to simply cascade lower or carve out a double bottom.

I’ll write up a full report covering the various sentiment measures in detail for the weekly sentiment overview on Friday.

Put Call Ratio
We had a historic reading in the commonly followed CBOE equity only put call ratio - the highest in years. As I mentioned then, for some strange reason, it seems that an inflection point doesn’t coincide with such panics in the option markets but instead follows a few days after. Well, it is a few days later.

Percentage Above Long Term Averages
This market is oversold. Is that too simple? Here’s a weekly chart of the small caps, Russell 2000 Index (RUT) showing the percentage above their 150 day moving average:

And here’s a daily chart of the large caps, Dow Jones Industrial Average (INDU), showing the percentage of stocks above their 200 day moving average:

The last time we had 10% of Dow Jones components trading below their long term moving average was when we were just finishing up the bear market of 2002-2003.

“Dumb Money Confidence”
One of the most important proprietary indicators that I watch from SentimenTrader.com is the “Dumb Money Confidence” index. It is an aggregate of many indicators and along with the “Smart Money Confidence” it shows where we are along the market cycle.

The most recent reading is 13 (the indicator runs from 0 to 100) which is extremely low. This is a result of the abysmal sentiment out there but it also reflects how extremely oversold we are now. The previous times we’ve had such a low reading has been in August 1998, October 1998, September 2001, July 2001 and February 2003.

Financial Sector
Since a huge portion of this market decline is related to financial stocks (through the mortgage credit crisis), it is vital that they be the ones to lead any rallies. We’ve seen this sector jump around on the rumor du jour but what we really needed was something substantial.

Which we got on early Tuesday. While the general market rallied 3%, financial stocks were up 7%. This was an obvious reaction to the Federal Reserve’s new $200 billion intervention. The number is puny compared to the nominal amounts at stake in the financial markets. But what is important is that for the first time during this crisis, the Fed is using a scalpel rather than a sledgehammer.

Stock and Bond Dislocation
I’ve already mentioned that these two important markets were becoming more and more dislocated: stocks were cheap and bonds expensive When the two markets become disjointed it usually flags an important inflection point.

Sentiment Surveys
The common sentiment measures like AAII and Investor’s Intelligence haven’t changed significantly from last week so I won’t delve into the details. Most are continuing to show some level of bearishness, which as contrarians we should find comforting.

Consensus’ bullish percent continues to fall faster than a pervert’s pants. It is now at 23% - the lowest since early 2003, when the cyclical bull market began.

LowRisk, being the schizophrenic measure that it is, has now swung completely to the other side. From last week’s 64% bearish to only 36% bearish this week. The bulls are at 46%, easily outnumbering the pessimists.

ROBO Put/Call Ratio
The CBOE equity only put call ratio is the most famous measure of option sentiment but there are a few others. I’ve mentioned the ISEE Index several times (gathered from the ISE options exchange).

I think it is high time I mentioned another. The ROBO ratio is a concoction brewed every week by Jason Geopfert, of SentimenTrader.com

The simplest and most common use of options by unsophisticated traders is to buy a put or buy a call. So Jason takes the detailed raw data from the Options Clearing Corporation, finds the trades for 10 contracts or less to open a position (both puts and calls) and uses them to calculate a ratio. Hence the name: Retail Only, Buy to Open. Simple, and straightforward; but ingenius. That’s Jason for you.

The only disadvantage is that there is a week’s time delay so it is best used in the long to intermediate time frame.

Right now the ratio is at 0.68 - in lieu of a chart: in recent years we’ve seen these levels in July 2004, August 2006, and March 2007.

Meaning that right now, retail option traders are skeptical of the stock market’s ability to recover. As they’ve been since the beginning of the year.

Commitment of Traders
The most recent Commitments of Traders report is showing the commercials (aka, smart money) slightly more net long. at $7 billion (aggregate futures contracts).

That’s a far cry from the unbelievable extremes that they reached last summer in August. Starting in July 2007, as prices declined, the commercials doubled up on their long bets again and again until they reached a brain melting $40 billion net long exposure in August (see chart):

In contrast, the small speculators category (aka, dumb money) decreased their net long exposure to $11 billion net long. In January, they were at an extremely low $6 billion net long (aggregate futures contracts) and are actually still close to their record lows for the past few years.

On the whole, the market underwent a definite extreme position in January. So far it has refused to burst out of that oversold position, preferring instead to meander about, seemingly aimlessly. The danger for the longs is that it could drip lower slowly, not providing any panic short term lows, but instead simply cascading into lower lows and lower highs.

Personally I doubt that because all the indicators that I’m looking at, like those I mentioned above, tell me that we are in a bottoming process. But I could be wrong of course. Maybe there is a piece or two that I’m missing.

The latest Commitment of Traders report had a surprise inside. The “smart” money, commercial hedgers now have an all time record net long position.

If you recall I’ve mentioned the Commitment of Traders Report a few times and pointed out the aggregate net position of the commercials.

The usual behaviour for commercials in a rising market is to either reduce a net long position or to increase a net short position. After all, they are commercial players who already have exposure to the stock market which they want to hedge.

But something quite singular has unfolded recently. Since around April 2007, eventhough the market has gone up, the aggregate nominal value of the commercials has been net long. And it has remained net long over a prolonged period of time.

Now, it has actually increased remarkably and broken all previous records. The aggregate nominal value of the commercials net positions is a historic $14 billion (appx.).

And it is even more remarkable when you consider that not only have the markets been rising lately, they are either in or almost at, all time highs.

As I look across at the internal metrics and various indicators, most are ambivalent or neutral. The COT is by far the most bullish one out there right now. However, I do want to point out that with this sort of indicator, which is dealing with dollar values (of contracts), we have to be careful.

Over time, the market tends to increase in size, capitalization, and with it commensurately, volume and trading activity. If we compare today’s market, on a dollar basis to itself, say 5 or 10 years ago, we are comparing apples and oranges. This is why stock market activity is usually equalized using GDP or other economic gauge.

In the same way, the COT data I mention above is in dollar terms and therefore, we have to take it with a grain of salt. The fact that it is now at a historic extreme may not be due to simply an extreme in sentiment but in the increasing size of the market and contracts traded.

But while we consider that caveat, there is no doubt that the picture it paints over an intermediate time frame is still quite bullish.