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Sunday, June 30, 2002

I left off last week stating that the odds of an upside reversal were tremendous, so any cascading moves lower would be buyable for an intermediate-term rally.  Those coming into the week long are now in an only marginally better position (assuming one held and using the indexes as proxies), but those who have shortened their time frame due to market conditions and are reducing overnight exposure should have had a very good week.  The S&P jumped over 5% while the NDX rallied nearly 10% from low to high last week, which presented some truly great opportunities from the long side.  Although the evidence isn't as compelling as last week, I continue to believe that there's a chance for further upside on an intermediate-term basis.

This is why...

BULLISH

NYSE MEMBERS REPORT - The specialist short ratio increased to 37% from 32% during the previous reporting period.  I was looking for another decrease here, as I thought the breakdown far away from any support would give the public short-sellers more confidence.  It may turn out that the breakdown from S&P 1050 in the prior week spurred the initiation of a flurry of short positions which were then covered into the large drop the following week.  The S&P declined nearly 4% at the low that week.  Although I would have much preferred to see additional public shorting into these declines, we must not forget that a reading of 37% is still bullish.  Over the past five years, I've found that readings under 40% or so are a positive sign for the market going forward.  Also, as I've stated repeatedly, I do not use this indicator for short-term timing.  The study posted to the site suggests that the readings we have recently encountered bode well for the next few MONTHS, not necessarily so much the next few WEEKS.  Next week's reading will encompass a period that saw an impressive rally off of the 14th's opening low that ultimately failed.  We'll see if that failure further emboldened the public shorts.

COMPOSITE MODEL - We saw an incredible run of 22 straight days over 65%, which is much greater than anything seen over the past few years.  The model only dipped below 65% on Friday, to close at 60%.  The closest string of high readings we had encountered previously was 15 days in September 2001.  The negativity seen during this decline has been incredibly persistent.  Although I regret that I issued the buy signal so early, the degree of pessimism we've seen over the past two weeks should serve us very well over the coming weeks and months.  I would be very surprised if we didn't see at least 1050 on the S&P before this model drifted back down to a sell signal. 

SENTIMENT SURVEYS - Not a great deal of change here overall, as the II bullish ratio, AAII bullish ratio and Consensus bullish percentage all remained close to where they were last time  The lowrisk.com bullish ratio also didn't change a whole lot.  I think with the volatility we've seen, if these surveys were conducted on any other day, then the results could vary wildly.  We did have two dramatic changes, one bullish and the other bearish.  The Market Vane bullish percentage reached 18% last week, which is the third-lowest reading since 1982.  The only lower readings were 17% on 6/18/82 (which preceded a 58% rally in the NYSE Composite over the next year) and 15% on 5/25/84 (which preceded the ensuing 100% return on the S&P over the next three years).  I understand the argument that these readings were registered at the beginnings of one of the greatest bull markets in history, and we don't have the same conditions now.  I don't find much value in this survey as a long-term tool anyway.  But both of those readings also coincided with impressive intermediate-term rallies with very limited downside.  On the other hand, the Neuer Market survey came out with a simply huge increase in bullishness, particularly by the small private investor.  The private investor went from 28% bulls to 44% and from 48% bears to 12%.  The institutions also showed a marked increase in bullishness, although not nearly as dramatic as the privates.  This survey includes responses taken up to June 27th, so if it had been taken even one day before (due to a large reversal in that market), the responses could have been notably more bearish.  One thing that seems to stick out among all the surveys is that the small, individual investor (most closely reflected in the AAII and Neuer Market surveys) are not being shaken out during these large declines.  They are moving from bullish to neutral and back again, and not taking an outright bearish stance.  The standard argument states that we will not see a long-term bottom until this "dumb money" is converted to the bear camp for good - or anecdotally, until your neighbor stops asking you if now is a good time to buy.  If that's the case, it would take a truly frightening scenario to bring that about, as we now have unprecedented access to financial news, most of which suggests that stocks are the way to go for the long term.  Perhaps these small investors have wised up to the fact that the market will not go up 20% a year for the rest of their lives, but that it WILL go up, enough to make it the best place for their money.  Perhaps they are not so much the dumb money anymore, but instead are the patient money, with a longer time frame than the futures traders or institutional money runners polled in some of the other surveys.  I don't care to hear any stories about how your co-workers ask you if they should buy CSCO now that it's a teenager - quite frankly, I'm really tired of all of the anecdotes.  I'm asking you to consider the possibility that the wave of financial inundation has perhaps changed the investment landscape forever, leaving in it's wake a generation of more patient and, yes, sophisticated (to a degree) investors.

AIM - It should be no surprise from the paragraph above that this model also did not show a great change, increasing mildly to a reading of 80.9.  We are now officially on a buy signal due to the minor reversal in the model last week, although as you can plainly see from the chart posted to the site we aren't as extreme as the past few intermediate-term bottoms.

STEM - The severe decline at points last week drove the 20-period moving average to heights never before seen, although they were temporary enough to take the 50-period moving average to a level last (and only) seen in September of last year and not set a new high.  The reversal off of the lows mid-week was not enough to drag the moving averages much lower, unlike the last rally attempt in mid-June.  If we get a rally continuation on Monday and Tuesday, there's a good chance both MA's will drop well into neutral territory, but any mild consolidation will likely keep this model elevated for days on end, which of course would be a positive sign going forward.

TRIN - We still have somewhat elevated levels here, and should there be any kind of a decline early next week, the 10-day TRIN will almost certainly record another 1.50 reading.  We will be dropping readings of .36 and .92 on Monday and Tuesday (respectively), so all it would take is a reading over 1.0 on Monday to push the moving average to that widely watched 1.50 benchmark.  Seeing as how the three-year average reading of the TRIN is 1.11, it's not hard to imagine we get another MA reading over 1.5 next week.  The Nasdaq TRIN 10-day moving average remains over 2.0, which as I mentioned last week has only been seen a couple of times in the past few years.  These indicators continue to suggest that we are extremely oversold on an intermediate-term basis.  As the study posted on the site several weeks ago reveals, the more time that passes, the more likely it is that we will rise.

CBOE RATIOS -  Over the past couple of weeks, I have expounded on the historic levels of pessimism we were seeing, and how they have lead to market outperformance a significant amount of the time.  The put/call ratio moving averages, the open interest ratio, the OEX p/c - total p/c spread, the open interest p/c - total p/c spread - all of them suggested (and continue to suggest) that the intermediate-term bias is up.  With that said, Friday saw the lowest put/call ratio (.66) since May 23rd, which was close to the top of the most recent leg down.  Although a reading of .66 is not extreme by any measure, and is at worst just on the lower end of neutral, this type of reading when we are below every imaginable daily trend line is somewhat bothersome.  Overbought conditions or excessive optimism in the context of daily downtrends are what make short-sellers salivate.  On the other hand, the OEX put/call ratio remains a very low and very bullish .71 (remember, I don't look at this ratio in a contrarian manner), suggesting that the big money is betting on further upside, at least for the moment.  The past two days have seen readings in the bottom 5% of all readings over the past 18 years.  Following a Wednesday reading over 2.0, this is a very welcome sign.  Perhaps the big money panicked at the low, and has now come to realize that the worst may have passed for the time being.

NEUTRAL

STEM.MR - I said last week that we had seen 25 straight periods over 95% in this model, which was the longest streak on record.  We got a nice pop early in the week, which then fizzled as the model dropped close to sell territory.  The drama on Wednesday morning of course prompted another buy indication, which lead to the sell trigger on Friday morning.  Although the model has now gone back to neutral after the decline Friday afternoon, we're still low enough that any rally attempt on Monday morning would likely generate another sell indication.  I'm not thrilled about selling into such oversold longer-term conditions, but on a very short-term time frame, it may not be such a bad idea when almost every trend line one can draw is pointing down.

BREADTH RATIOS - We're stuck in neutral here across the board, with a chance at becoming overbought with further upside next week.  The advance/decline ratio 10-day moving average will be dropping a string of six large negative readings beginning on Wednesday, so if we get a rally going into late next week, we could become extremely overbought in a hurry.  The daily cumulative TICK indicators are also creeping up towards overbought, while the intraday indicators are already there (or close to it in the case of the Nasdaq).  At its peak on Friday, the intraday NYSE cumulative TICK indicator reached +5,400, which was the highest reading since 6/17 (+6,115) and 5/31 (+5,996), both of which served as almost ideal shorting opportunities.  If this most recent rally is any different from the others, it must churn in here while the TICKS settle down.

VIX and VXN - I stated on Thursday (in the Indicator summary on the overview page) that the VIX had made a picture-perfect reversal.  When the VIX makes a spike high like it did on Wednesday only to reverse and close lower on the day, it bodes very well for a short-term upside move.  But now that the VIX has declined 17.5% from the high (and the VXN 12%) and they have both dropped below the 10-day moving average while the RSI is below 50, we have to consider them neutral at best.  There's certainly nothing here that says complacency made a stunning comeback, but we've also passed the point of maximum reward/risk.

TOPM - This option pricing model dropped significantly on Thursday and Friday, which would suggest that puts were being bid heavily in relation to the opposing calls.  That would be a short- to intermediate-term positive, although to be quite frank I'm not putting a whole lot of faith in this model after the recent leg down had no effect on it.  With skyrocketing put/call ratios and a spiking VIX, there's no reason the model shouldn't have dropped.  I'm still going through various scenarios with it to try to determine if there's an error but so far I haven't been able to find one.

COT - For the week ended 6/25, the commercials liquidated 59,316 long positions while covering 49,181 short contracts for an addition to their net short position of 10,135 contracts.  The small specs liquidated 46,798 long contracts while covering 25,725 short contracts for a subtraction from their net long position of 21,073 contracts.  When I initially saw the large net change in the small spec position, I thought it might be due to the effects of index futures expiration on the 21st.  I went back and looked at the past decade's worth of expirations and tallied the net weekly change.  It should be noted that there are four expirations each year (March, June, September and December) so the total expiration week sample size was just under 40.

What this table means is that, for example, the average change in the small spec's net position over the past decade has been +587 contracts (or 17.7%) per week in non-expiration weeks.  During expiration weeks, however, the average net change is -5,256 contracts (or 55.9%).  This week showed a decline of 22.7%, which is significantly SMALLER than the average expiration week change over the past decade.  So while the numbers on the surface look very positive, it may have been unduly influenced by expiration.  But even though a large number of long contracts may have expired, it also means that the small specs did not (at this point anyway) re-establish those long positions, which is an important shift in sentiment.  As of Tuesday's reporting period, the S&P was resting right on Monday's new low, so one would think that would have been a logical place for the small specs to make something of a stand.  In any event, the stochastics as a whole look more positive this week than they have in many weeks prior, which reflects a short-term positive bias.  The intermediate- to long-term picture is still neutral to bearish.  If you draw trend lines through the commercial and small spec net positions since the end of the bull market in 2000, both are still pointing in the wrong direction if one is looking for long-term upside in the S&P.  I would have to see a commercial net position of less than 30,000 short contracts and a small spec net position of less than 45,000 long contracts to even begin thinking that the long-term trend in this sentiment indicator may be changing.

As I said in the daily commentary, on Wednesday's panic open I was looking for the following levels of sentiment to measure how truly desperate the market was:

You can see that we exceeded or came close to most of the levels I had pointed out that I wanted to see, however I mentioned that it sure didn't seem "panicky" to me.  I think that what we did see may have flushed out a good number of weak long holders, but a bunch more probably rushed in at better prices.  At the first sign of a rally failure, these holders may decide to dump, exacerbating any inherent weakness.

The situation isn't as clear this week as it was last.  Last week, it was a good bet to me that any gaps down or cascading moves lower were buyable for a bounce, maybe even catching THE bottom on an intermediate-term basis.  This week, with the rally off of those lows, we're in a more precarious position.  We're getting overbought on a short-term basis, and when the market declines we will be facing a major test.  The sentiment studies I have done suggest that the test would likely hold, although another failure may generate the kind of fear so many seem to be looking for for a better bottom.

 - Jason Goepfert