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?

From a historically low reading of 10 earlier in the year, volatility as measured by the CBOE’s VIX has all but tripled. On Friday it closed lower but intraday it reached a high of 29.84.

That’s high both on a nominal basis and relative basis (see graph below). In the preceding two corrections, volatility only reached 20 something. And relative to its 50 day moving average, volatility is now about as stretched as then.

This is par for the course when we are operating with a correction thesis. Volatility spikes, the market gets spooked, smart money moves in (hopefully you) and the market resumes its merry way upwards.

But a funny thing happened that is giving me concern about this recent volatility spike. Funny as in weird. Not ha-ha.

VIX Futures
A little over 3 years ago, the CFE started trading in VIX futures. This allowed people to go long/short “pure volatility” for the first time. So we now have a futures market in volatility itself. And we can analyse this market like any other futures market.

Although we have limited history, what we see in market corrections is a move by the commercials to reduce their long positions in volatility and a concomitant move by the retail crowd (small speculators) to increase their long positions. A good example is last summer’s market action in June.

Smart Money vs. Dumb Money
So it is a bit disconcerting to now find the smart money commercial players in this market actually going more and more net long, even as the VIX has increased. And to kick things up another notch, the dumb money, small speculators are now extremely net short.

Perhaps the commercials are hedging some of their gargantuan net long index futures positions? or perhaps some other wrinkle is in the works? One solace we can cling to is that the only other time when the commercials and small speculators were this long/short in the VIX market was in July 2006. Which worked out just fine as the market continued to recover and roar higher.

Whatever it is, I’d still prefer to see the commitment of traders in the volatility futures market acting according to its past script.

Hat tip to Jason Goepfert at SentimenTrader.com