Trader’s Narrative

Here’s an interesting article from Barron’s Online today: The Best Way to Use the VIX

Bill Luby, editor of the blog, VIX and More, said, “A classic misuse of the VIX is as a market timing signal. The VIX is generally negatively correlated with the broad market indices, but this correlation waxes and wanes.”

This throws conventional wisdom a curveball right away.

He continued, “Further, investors tend to believe that absolute numbers for the VIX are sacrosanct, so that a VIX of 30 or 50 or 70 starts to take on a special significance [see Chart 1]. For the most part, my research and experience suggests that absolute VIX levels are much less meaningful than the current level of the VIX in relation to recent levels.”

This is something I’ve outlined more than a few times:

• Volatility Spikes Higher (But Not High Enough)
• VIX’s Distance From Moving Average Is Bullish
• The Volatility Index: It’s All Relative
• The Heartbeat of the Stock Market Goes Thump

Although looking at volatility through the prism of relative performance helps us to understand it better, it can still at times be elusive. This chapter of market history is just one of those times. What we have seen recently is such an outlier that even when we look at relative volatility, rather than absolute volatility, we still see an aberration worthy of extreme value theory. With one exception.

I looked at the CBOE NASDAQ volatility index (VXN) and compared it to its simple 150 day moving average. Here is where we are now relative to where we’ve been before:

In 1998, the distance of the VXN from its 150 day moving average peaked on early October, just as the market made the final low. In 2000, it peaked in mid April but the market was far from a lasting low. And that brings us to 2008 when the relative VXN peaked in late October.

My hunch is that during “normal” markets, the VIX and VXN provide great signals. But removed from a stair stepping bull market, things can easily become extreme and lose meaning. What we saw in early 2000 was the pricking of an asset bubble and its consequences. What we are seeing this year is the pricking of a credit bubble and its consequences. Until we once again see “normal” markets, the volatility gauges will be an interesting sideshow.

Here is a recap of the important sentiment news for the past week:

Sentiment Surveys
Retail investors and traders continued their complacent mood. According to Wednesday’s AAII sentiment survey, the bulls increased to 44.83% and the bears continued to fall, reaching a mere 33.33%.

Tuesday’s results from ChartCraft’s Investor’s Intelligence weekly survey resulted in an increase in bullishness to 30.3% and decrease in bearishness 48.3%

I continue to be a little disappointed by the rapid mood change shown by these traditional sentiment indicators.

Corporate Insiders Buying
Various sources of data for insider activity is showing a marked uptick in buying. Corporate insiders are considered to be “smart money” so this is a good sign. The fact that they are now buying cheap stocks means that they believe that stocks have fallen enough to be a compelling value. This isn’t so much a sentiment measure as a real measure of behavior. So in a sense it has more weight because what someone says on a survey is one thing, but what they do with their cold hard cash is another.

Volatility
Volatility hasn’t imploded, yet. But we are off the all time record highs of both the VIX and VXN. As well, we seem to have put in a small lower high with the VIX index ending at 55.14 - now it needs to put in a lower low.

Seasonality
The stock market has entered into positive seasonality. Although this doesn’t guarantee in any sense that the market will go up, it does mean that we have the wind at our backs. This may mean nothing when you consider that we are having one of the blackest black swan years.

Rydex Nova Ursa Ratio
It has been a while since I mentioned this sentiment indicator. Mostly because it wasn’t registering any extreme readings. Except for the most recent data point from late October.

The Rydex mutual fund family is in danger of becoming a vestigial financial vehicle. For those unfamiliar with this indicator it used to be the fast moneys preferred choice since it was the only mutual fund priced more than once a day and offered a way to profit from both the rise and fall in the market. Of course, with today’s plethora of ETF and levered ETFs Rydex has been left in the dust.

But the most recent ratio shows that the fast money switched heavily into the bearish market timing fund leaving the bullish one in droves.

Magazine Covers
Here are two interesting recent magazine covers. These are worthy of note and perhaps good contrarian indicators because they are general interest publications which usually do not focus on the economy or the financial markets. So the fact that they have devoted a cover and made it so excruciatingly negative in its symbolism is telling.

Source: Esquire Magazine cover article and New Yorker magazine

What a week. This will go down in history so make sure you pause and take note. Wall Street just had its worst week in history. So how is the sentiment landscape?

Sentiment Surveys
As I hinted earlier in the week, we saw some downright gloomy sentiment from all the usual surveys. Investor’s Intelligence, which monitors newsletter writers sentiment came in at only 25.3% bullish and a whopping 53% bearish. This is the lowest number of bulls since 1994!

Of the AAII weekly sentiment respondents, 60.8% believe we are in for more downside while only 31.5% are bullish (the remaining few are ambivalent). This is the second highest level of bearishness from the AAII sentiment survey. The last time was on October 1990. For a graph see: AAII Sentiment.

Anecdotal
I’m hearing a lot of fear and loathing from all corners. Trader Mike’s blog is getting a lot of traffic coming in from people googling “how to short” which is always a sign of capitulation of some sort. Regular folks are disgusted with the market and fearful of their retirement security. You can see comedians and commentators on TV talking about the stock market every night. Steve Cohen, the legendary hedge fund virtuoso, apparently threw in the towel and told his whole trading floor: “You’re all idiots. We’re going to cash. I’ll see you in January.”

Rydex Market Timers
Before the rise of the ETF phenomena, the Rydex funds were the only vehicle which allowed market timers to jump in and out of the market, and to even take short positions (by buying a fund). Although ETFs have definitely eroded the popularity of Rydex compared to when it was the only game in town, they still have a very strong following.

Right now these market timers have skewed the asset ratio to a degree that we haven’t seen since the bottom of the bear market in 2002 and early 2003. Of the the total assets held in the Rydex S&P 500 Index funds, only 15% are long.

Hulbert Newsletter Sentiment
At the start of the week the Hulbert Stock Newsletter Sentiment Index (HSNSI) was -36.1%. Meaning that the average short term market timing stock newsletter was suggesting to their readers that they allocate that percentage of their portfolios as a short position. Going by absolute numbers, that is a very low reading.

But just a few months ago in July, the HSNSI was even lower at -42.9%, when the market was trading at a much higher price than now. To put both in perspective, in the aftermath of the September 11th terrorist attacks on the WTC, the HSNSI dropped to -13%. The lowest it got in the ensuing bear market was in July 2002 -15.14% and then a bit lower, -19.2% on March 10th, 2003.

Option Markets
I’m still puzzled by the way the options market has been acting because I expected it to show much more fear than it has. For example, the CBOE put call ratio (equity only) hasn’t even taken out the highs we saw in September (1.18), never mind those of March 2008 (1.35). The ISEE sentiment ratio also continues to show a total disregard for put options from retail traders. With the exception of Tuesday which saw it drop slightly below par, the ratio has shown that retail traders are actually opening more call than put positions!

Volatility
Are you sitting down? This week we saw implied volatility levels which eclipsed the 1987 Black Monday crash. The CBOE volatility index wasn’t trading or calculated back then, obviously. But it is “reconstituted” as if it were. The old method took volatility (VXO) to 86% (intraday high of 103%) . The new method (VIX) to 66% (high of 77%) and for the Nasdaq (VXN) 71.6& (intra day high 82.4%). It’s a good thing we are no longer using paper for charting or we would have to glue on a top piece to the right side edge of the graphing sheet.

Contra Hour Stand
The bulls made a brave stand at 3pm, otherwise known as “contra hour”. But in the end they failed to close above or even break even. Monday is round two. Lets see what the G7 meeting can accomplish.

Headline & Magazine Covers
You don’t have to look far to find incredibly bombastic headlines. Some would say they fit the times. Others that in hindsight they will be another sign of contrarian opinion. Here are two from the Economist magazine (a favourite of Sarah Palin, along with Pravda, the Witchita Gazette and everything else printed since and by Gutenberg):

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’

We went from lukewarm, boring sentiment overviews to white hot. As the saying goes, “May you live in interesting times”.

Volatility Indices
I complained in last week’s sentiment overview and the VIX responded giving us a real spike to 42.16 (VXN to 40.44).

These are levels at which we can comfortably say there is true fear in the market. And although there is nothing to stop us from actually seeing higher volatility numbers, there is no doubt now that we have crossed into the serious.

CBOE Put Call Ratio
It was a little dissapointing to not see this measure of fear spike higher. The spike only took the equity only put call ratio to 1.18 - a respectable level of fear but not even close to previous records. For example, consider that going back just a few months to March 2008, we saw 1.35 - as well, the ratio collapsed to 0.51 by the close of Friday’s trading.

ISEE Sentiment
The ISEE sentiment index measures the level of interest from the retail options trader in calls and puts with the resulting number representing a fear index of sorts. Not surprisingly, Friday’s level of 66 is one of the lowest we’ve seen.

The record was set on March 10th, 2008 with a paltry reading of 56, meaning that almost half the amount of calls were traded to puts.

Previous ISEE ratios below Friday’s are:

March 8th, 2007 — 58
October 11th, 2002 — 60
August 22nd, 2006 — 63

And on March 7th, 2007 and July 3rd, 2007 the ratio was tied with (September 19th, 2008) Friday’s at 66.

What is remarkable is not the low number we saw on Friday because after all, that is to be expected when the market is in shambles, but that there is a total disconnect between the two. Let me explain. While the market was careening lower on Monday and Wednesday, the retail options traders as measured by the ISEE were yawning their way to actually trading more calls than puts, putting the ratio slightly above 100.

Then on Thursday and Friday as the stock market screamed higher, the ISEE ratio fell precipitously as the retail traders furiously bought puts over calls.

So can this possibly mean?

Assuming that the data is correct, one way to interpret it is that what we saw in the final days of the week was simply the mother of all short squeezes (courtesy of the US government).

It would be premature to interpret the seemingly bullish market action to mean that buyers have reasserted themselves and buried the sellers in an orgy borne of relief. As I mentioned when I railed against the government’s temporary ban on short selling, each share sold short represents a future buy order. What we saw in effect was all those future buy orders which would have naturally have been traded over months and weeks, jammed through in a matter of days.

So it seems that not only is the retail options trader not buying this rally at all, they are finally getting seriously worried.

Lowry’s 90% Up Day?
I got a lot of people asking me if what we saw was the endangered 90/90 up day as defined by Lowry’s Research. Intuitively it felt like one and the numbers bear it out - almost.

To be precise, we saw 89.5% and 87.8% upside volume on the NYSE which is 90% if you squint. I don’t want to go around second guessing valued indicators but I can’t help but get a nagging feeling that a rally caused by the government interfering with the normal working order of the market just isn’t genuine.

Sentiment Surveys
The Investor’s Intelligence survey results are as of September 16th, which was before Thursday’s harrowing down day. Still, there was a significant uptick in bearish sentiment with 43.7% of newsletter editors pessimistic and 37.9% optimistic. Next week’s survey will be much more meaningful as it will demonstrate whether the recovery by the end of the week is perceived to be the real deal or not.

The AAII sentiment survey came in for the second week in a row with more than half the respondents bearish: bulls 27.21% neutral 18.37% bears 54.42%. Within a strong bull market this would be enough to get any contrarian excited but we’ve seen +50% AAII bearishness this before and it has disappointing at times. But the historical pattern is still on our side with the market bouncing back impressively on average after similar situations.

Finally, the Hulbert newsletter sentiment index which measures a subset of the stock newsletters which time the market did fall to -36.6% at the beginning of the week but recovered to -35.9% on Thursday. This is meaningfully low but unfortunately it is not even as pessimistic as what we saw in July when the market was trading higher than now.

Conclusion
Undoubtedly we are seeing major fear in the market and trusted indicators are almost unanimously pointing to the same conclusion. What muddies the water is not only the severity of the financial crisis which dwarfs the others we have weathered previously, making comparisons moot, but also the internationally coordinated government interventions which interfere with the normal course of the markets.