Apr 28, 2002

sentimenTrader.com

Sunday, April 28, 2002

An interesting week to say the least. For the first time in a long while, we got a number of STEM.MR signals in the same week, almost every day. Most of them were able to take advantage of small rallies, usually in the morning, but by the time the model went to neutral, the rallies failed and we went lower once again. That cycle will not last long, however, since at some point the selling will ease and the trend will change. If the selling continues at last week's pace, the S&P will be at zero in approximately six months. So let's keep our heads, figure out where sentiment lies at this point, and try to gain an edge over those who are letting emotion destroy their account balances.

Let's look at our indicators one by one...

BULLISH

TRIN - We went over 2.0 several times on Friday, which is a fairly extreme reading in itself. It pushed the TRIN.MR to 75%, which also is fairly extreme. The longer-term moving averages have not had time to cycle back up to the 1.5 area that is commonly perceived to mark extremely oversold conditions, but remember it is coming off just such a reading (1.60 in fact) on 4/15. Some of the better bottoms we have seen recently have seen the 10-day moving average double-dip over or close to 1.5, so we may be setting up to see the same thing this time around. Over the next two days, the moving average will be dropping figures of .37 and .82, so if we get even moderately oversold readings Monday and Tuesday (say around 1.8 or so), it would push the 10-day average near 1.5 once again. There's nothing magical about that number, but it has marked important bottoms in the past and is a good gauge of the degree of extended selling pressure that is happening at a pace that is unsustainable.

CBOE PUT/CALL AND OPEN INTEREST PUT/CALL - I said last week that although these numbers were bullish, due to the non-confirmation we were getting from several other options indicators, I was placing less weight on these numbers. That proved to be accurate, as the market didn't have so much as a hiccup on the upside on a daily basis. We have a different story this week, however, as both ratios are in the upper 30th percentile of all readings over the past year, and we are getting confirmation from our other indicators that fear has increased. These ratios are not at extremes, and there is certainly room for them to increase, but nonetheless they are in bullish territory.

VIX and VXN - For the first time since the February bottom, the VIX has popped out of its 10% band over the 10-day moving average on a closing basis. Although that on the surface is bearish, the fact that fear has increased quickly, and to a significant degree, makes it much more likely that we are closer to a bottom than a top (or an extended continuation of the current trend). The VIX is now 12.5% above its moving average, which places it in the top 7% of all readings over the past three years. On an absolute basis, a VIX reading of 24.5 is nothing special, but I continue to think it will be a mistake to rely on absolute levels on this indicator. Watch the trend about a moving average, and it will serve you in better stead. The RSI is also near 80, which is overbought. HOWEVER, like I said when the VIX was heading down below 20, this indicator is telling us nothing until it makes a reversal. It could go to 30 or 40 or 50 as the market collapses, so don't jump the gun and assume that it has to reverse here just because it is outside of an arbitrary band level. Somewhat surprisingly, the VXN is still well within its own 10% band around the moving average, even while tech stocks have taken a severe beating. Quite frankly, I'm not quite sure what to read into that. I'm not buying the surface argument that traders and investors are complacent, thus keeping the figure low. I think there are underlying dynamics that are suppressing the VXN, whether it simply be apathy for tech stocks or a preponderance of other options strategies that dampen implied volatility levels. It concerns me that the VXN is not rising more quickly, but I'm not too concerned.

STEM.MR - With the rise in the TRIN and VIX over their respective moving averages, this model has spent a good part of the past couple of days over 90. It would be quite rare for it to be over 90 for any more than about two or three days, though, so two things are possible at this point. One, we rally from here are relieve the short-term oversold condition. Or two, we keep going down and the moving averages for the underlying indicators increase, thus relieving the pressure. Of course, those are obvious, but as trading (and investing) is nothing but an odds game, we have to rely on the odds to tell us what to do. At this point, looking at this model, the odds of a rally are greater than the odds of a further decline (short-term).

TOPM (THEORETICAL OPTION PRICING MODEL) - This is a proprietary index I have created and have mentioned before, although credit has to go to Max Ansbacher for the idea. I create synthetic options exactly 30 and 40 points out of the money with a fixed expiration of 49 days, and compare the pricing of the puts to the calls. This allows me to compare option prices apples-to-apples, without the distortions of expirations and options that are different amounts away from the current index prices. Essentially, when the index is high (over .55), calls are being bid up (bearish for the market from a contrarian standpoint) and when it is low (under .40), put prices are being bid (bullish for the market). The current reading is .37, which suggest that puts are in demand and the market makers are adjusting prices upward to mediate their risk. After all, you don't think they're going to always give you cheap insurance, do you? I recommended in the March 24th commentary that if you were concerned about a market drop (and from reading the commentary and looking at the indicators, you certainly should have been), you should buy puts. Those very puts are being bid very aggressively now, which would have netted you a very handsome return. For example, on March 25th with the OEX at around 575 you could have bought the May 570 puts for around $13.50. Those very same puts are now around $38. Now I am not recommending speculative options trading for anyone, but if it fits into your methodology or you want portfolio protection, I suggest you look into that market.

BEARISH

COT - Last week the commercials decreased their net short position by about 1,000 contracts (about 1.1%) while the small specs decreased their net longs by 3,250 contracts (about 3.2%). That is certainly an improvement, but if you take into account the S&P dropped 1.8% during that reporting period, it's rather disappointing. It depends on what happens Monday and Tuesday of course, but the S&P has dropped 2.1% during the current reporting period, so it will be quite telling to see this week's figures. As you can see from the stochastics on the COT page, we are coming off historically bearish conditions here, but we have a long ways to go before we can consider this bullish or even neutral.

NEUTRAL

BREADTH OSCILLATORS - These oscillators are getting to be oversold, but they just aren't oversold enough to consider them anything other than neutral at this point. The advance/decline ratio will be dropping some pretty large overbought readings over the next few days, so provided we don't have an upside explosion over the next few days, this indicator should drop into oversold early next week. I have a slightly bullish tilt here.

NEWS ITEMS - Once again, there is nothing unusual happening on the news front (as far as reactions go). Bad news - stocks go down. Good news - stocks go up. The economic reports this week were rather mixed, so that won't tell us much. Although stocks are going up less than they probably could on good news, the fact that the broader market is in a funk will have a dampening effect. Until we see stocks (and the broader market) begin to defy reason and go up on bad news, we cannot consider this indicator to be positive.

STEM - At 68, the fast line (20-period moving average) on this model is approaching the BUY area, but the slow line (50-period moving average) is still stuck in neutral at 53. On Monday, we will be dropping a string of overbought readings, so if we have another down day, the slow line could perk up quite a bit. Probably not enough to generate a BUY signal yet, but it will be getting close.

SENTIMENT SURVEYS - We are neutral here as well. We would be bullish if it weren't for the Investor's Intelligence survey, which is stubbornly stuck at over 50% bulls and 30% bears. Some are hailing the fact that the % bulls decreased while % bears increased, which of course is positive, but the same thing happened two weeks ago and look what happened after that. We have been gyrating around these levels for three months now, even while other surveys have been improving. The Market Vane % bulls is in the lower quarter percentile over the past year, and the Consensus Inc % bulls is in the lower 15% of all readings over the past 10 years. The AAII numbers are neutral, but you know I don't put a whole lot of weight in those numbers anyway. I have to think that next week's numbers, with the dramatic decline over the past week and the break of support levels, should show a market increase in bearish sentiment.

AIM - With a current score of 44.5, we are still neutral in this model. Unless and until the II survey (which has an important weighting in this model) comes in with better numbers, I don't see a buy signal being generated here for some time.

SPECIALIST SHORT RATIO - I plan to have a page for this indicator up soon, but as it has a large lag and is very long-term, I'm not in a huge hurry. The current reading is 44%, meaning specialists on the NYSE are initiating 44% of all short positions (the rest are being initiated off the floor, e.g. retail). When the number is high (say over 50%), that means specialists are shorting more, which would happen when the order flow coming in is overwhelmingly buys. If everyone is buying, who is selling to them? The specialists. Likewise, when the figure is low (say under 40%), that means others (usually the public) are shorting relatively heavily. So, high figures usually come at or near tops and low figures usually come at or near bottoms - there's a reason most specialists are very rich. At this point, we're in the middle of the range, so I don't think we can read too much into this indicator now.

Last week I expected an increase in volatility, which I think you could say was true. I also had a neutral bias, which I am carrying into next week as well. I am becoming more and more bullish as we drop, but I just don't see us at a point where sentiment would support a sustained rally. Some of our indicators, mostly short-term, are oversold and saying we should bounce here. But the longer-term ones are still neutral to slightly bullish, which suggests there is further downside before a good rally can take place. I would not be surprised to see a rally next week, but I would really like to see a washout session or two, taking us down to support levels, with fear showing a marked increase. However, there are A LOT of other traders looking for the same thing, which makes me think it is less likely to happen. A rally, however, would catch many people off-guard and could spur a round of short-covering.
I know that's not saying much, but until we get a clear edge from our indicators, I am on the sidelines longer-term.