Trader’s Narrative

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):

Today’s market action is giving a lot of people the idea that what we saw last week was a perfect bull trap. Meaning that we’re about to have another whoosh down. Right now, I don’t buy that.

We are simply witnessing the return of volatility to the markets. Today the VIX and the VXO jumped by more than 30% (the VXN jumped almost 19%). This is the largest one day jump since the first day of trading after September 11, 2001. Historically, large increases in the volatility index correspond to positive returns in the S&P 500 both short term (the following day) and longer term (10 trading days).

There are some cross currents that give me pause though. For example, that this decline has transpired over only 13 trading days, that the small speculators in the index futures market have upped their bullish stance in the face of the decline and finally, that small traders are buying more calls (to open option positions) than puts.

So it is quite possible that we’ll go down to revisit the lows of last week. Or even zoom past them to flush out these pesky small speculators who are long right now. But for me, that wouldn’t negate this level being a significant market bottom. The reason I hold that view is that this backing and filling happens in almost all significant bottoms.

At inflection points, the market shakes with more vigor than a wet dog, trying to unhinge everyone’s position and forcing maximum pain to the maximum number of participants. It needs to do this because this is how it gathers fuel for the next expansionary phase:

What I’ll be watching for, as this volatility plays out, are sectors and individual stocks that will hold their own or go on to run higher. Those will be the next batch of leaders to ride as longs.