Trader’s Narrative

Monday’s free falling market finally brought us some indication of real fear in the market. The indicator that got many talking was the S&P 500 Index volatility index (VIX) being pushed higher than what we saw at the last financial crisis in 1998 (when a few PhD’s from Chicago almost took down the world economy with a little hedge fund called LTCM).

I wanted to take a closer look to see that spike in its proper context. So here is a long term chart of the VIX:
Continue reading ‘The Heartbeat Of The Stock Market Goes Thump’

This week’s sentiment overview is a challenging one to write because every indicator I look at is either stuck in neutral, lukewarm or middle of the road. The market isn’t giving us any clear edges. I’ll do a quick run down to show you what I mean:

Sentiment Surveys
As I mentioned, the Investor’s Intelligence sentiment survey continues mired in neutral with 37.8% bulls and 40% bears. Things haven’t moved for 3 weeks.

ISEE Sentiment
Not to be outdone, the ISEE Call/Put index ended the week at 101. Which means that retail traders were completely balanced in their preference for puts and calls.

Volatility Index
Neither the VIX and the VXN index are giving any cause for concern. Their nominal levels, 23 and 27, can be argued to be “high” but certainly not high enough. Their relative levels are also lukewarm.

The VIX is only trading at 6% above its 50 day moving average and the VXN at 4% above. To put that in perspective, recently in mid-July, both of the volatility indices spiked to more than 20% above their 50 day moving averages.

Conclusion
Putting together the neutral sentiment indicators with the weak technical picture and the historically bearish month of September, gives an unmistakable signal that this is not the time to be a buyer. In fact, it is time to sell and sell short.

A conclusion which is echoed by perhaps the savviest market participants, corporate insiders. According to the latest data (the ratio of insider buying to selling activity) executives are not at all enticed by the cheaper stock prices.

In a recent article, Mark Hulbert talks about the volatility index and mentions Samuel Eisenstadt a research director at Value Line who says that the current volatility readings don’t really tells us anything useful because the VIX isn’t high enough. Hulbert concludes:

The bottom line? Upon learning that the VIX is currently 26.57, we know next to nothing more than we knew before.

Which while true, proves that all models and all calculations provide answers which are constrained by the (usually unsaid) assumptions built into them.

The mistake that Eisenstadt makes is to look at the nominal value of the VIX - 26.57 or whatever it is at the moment. A cursory glance at the long term data shows that volatility can rise and crest at different levels. At one period in time 40 is “high” at another “80″ is the new “40″. If we insist on only looking at the nominal number we miss out on the real insight that data can provide.

To really understand where volatility stands we have to iron out the current zietgeist it finds itself in. To do that we can simply look at it relative to its 50 day moving average. Any moving average would work. I just like 50 as a nice round number - not too large, not too small. I’ve already shown you a three year chart of this.

Below you can see a long term (from 1998 to present) chart of the distance of the volatility index from its own 50 day moving average. I haven’t bothered to put up a chart of the S&P 500 index underneath the volatility chart because it should be obvious to any casual student of the market that all of the significant spikes correspond to important market bottoms.

Looking at the VIX this way shows us that right now we are indeed witnessing an event which in the past has reliably accompanied inflection points.

Click To Enlarge Graph:

Here’s a chart that I mentioned last week when I wrote that the VIX had spiked higher but not high enough. It is a slightly different way of looking at the volatility measure.

Instead of looking at the value of the VIX, in the chart I’ve plotted the value of the volatility index relative to its own 50 day moving average.

When the VIX goes higher it is important to be able to somehow measure if it is “high enough”. The most obvious way is to compare the VIX reading to past readings but as you know, over the long term, volatility cycles through high and low periods. What was considered high at one point, may not be high in another.

Case in point, the 2002 bear market bottoms saw the VIX reach 45 but since then we’ve been finding volatility “high enough” (to point out a bottom) in the 20’s.

By comparing the most recent reading in the VIX to the average of its most recent 50 consecutive readings, we can get an idea of how high volatility is compared to its most recent behaviour.

So this tells us that yes, we are really seeing a significant increase in volatility and therefore, the chance of a significant inflection point being around the corner is high.

But - there’s always a but! - notice that almost all significant market bottoms have a retest of the low within a short period of time. This was the case in the spring correction as well as the summer correction in 2006.

My point is that you don’t need to rush in and buy at the first glimmer of panic. If this is a real inflection point, it will be apparent soon enough and it may even follow the same script by retesting its lows.

So after warning you that we were headed into some shaky grounds on Monday morning (premarket) when the S&P 500 stood above 1540. And after the market fell to around 1510, saying that we had still some more room to the downside… Let’s see if I can continue this streak.

Lowry’s 90/90
No question today’s market action was severe. No doubt it was a Lowry’s “90/90″ day - where 90% of the points and 90% of the volume are on the downside. From the 3417 issues on the NYSE, 3144 of them closed down. That’s 92% to be exact. Meanwhile, volume on the NYSE was 95% to the downside.

Can you say e-x-t-r-e-m-e?

This is the sort of panicked, thorough selling that market inflection points are made of.

New Highs New Lows
This week I mentioned a few indicators that I was watching. The Nasdaq’s New Highs/New Lows indicator told me that we had more room to fall as it was still above 10. Today’s devastating decline took this indicator to just below, at 9.39. At these levels we can start to seriously look for a bottom.

Today, the New High/New Low Ratio also fell to extreme oversold levels. According to these two indicators, the number of 52-week lows (compared to highs) presents a compelling argument to go long.

Leaving aside market internals, a simple glance at the chart of the S&P 500 gives us a hint that the market may find its footing here. The February 2007 top which previously acted as resistance but can now become support:

Usually I leave volume off my charts but check out the volume today! Notice how in previous market inflection points, the surge in volume coupled with a wide range dark candle tends to signal a change in trend?

Most common indicators swung to extremes: The volatility index (VIX) spiked above 23 and met my request to go a tad higher. And the put/call ratio also spiked to a bullish extreme.

But the indicator of market health that I give a lot of weight to still hasn’t reached the kind of wash-out extreme that I’d like to see:

I’d prefer to see a real washout that would be a reading of 20-something. Similar charts for other percentage of stocks above 50 day moving average for indices like the Nasdaq 100 are also low but not low enough yet.

We could still bounce from here, especially as a gap up open tomorrow morning. That’s why right after 3pm I bought a bit of Ultra S%P 500 Proshares (SSO). The last hour of trading is known as “contra-hour” for good reason

What I’m most interested in seeing is how sentiment reacts to this recent decline in the markets. If we have real fear (increase in bearish sentiment), then we are probably all clear for another leg up in the bull market. But if people are complacent and do not flinch, things could get ugly.