Jul 28, 2002

sentimenTrader.com

Sunday, July 28, 2002

During last week's commentary and the early-week daily commentaries, I updated the statistics seen at past bottoms compared to what we were currently seeing. Obviously, there was a positive correlation between the events, and if history was any guide whatsoever then we should have seen a major low at any time. The gap down on Wednesday with severe readings in the panic indicators (VIX, TICKS and A/D) was an excellent opportunity for those of you not believing that we were headed to zero within the month. We've now had the largest percentage low-high rally since September in the S&P, and on tremendous volume. That is not typical, and usually happens at significant market lows. The NDX is a different story, but we WILL know early next week what the resolution will be. The NDX has now put in two inside days in a row, and, like a spring being coiled, it is going to make a large move one way or the other very soon. Traditional technical analysis would suggest that the breakout will be to the downside as a continuation of the larger trend, but that does not take into account sentiment extremes. Considering the fact that we have reached an historic level of oversold and pessimism about the future, the odds as I see them suggest an upside breakout of large proportions.

Indicator Summary:

BULLISH

NYSE MEMBERS REPORT - The Specialist Short Ratio rose a bit to 38%, which is still under historical norms. Although there has been a secular decline in this ratio, a reading of 38% is still relatively low and still bullish. Because of the reporting lag, the most recent information we have available to us is for the week ending July 12th. This is the week that the NYSE Composite index was testing the September lows. Next week's release will encompass the week where the lows decisively broke and the Composite suffered an 8% loss, so we could see some very interesting information next week.

COMPOSITE MODEL - We're finally getting a meaningful reversal in this model, as it has declined from an all-time high of 89% to the current reading of 71%. The relaxation of the stretched VIX, TRIN and put/call ratios have accounted for most of the decline, and I suspect we will not see similar highs in this model for quite some time. We have now spent 19 straight days above the buy threshold, so it is virtually impossible to try to forecast what might result from such prolonged and excessive pessimism. Several of the components of this model have set new all-time negative extremes over the past 10 days, so we are truly in uncharted waters at this point.

SENTIMENT SURVEYS - The persistent decline in the broader averages has kept a lid on optimism, as the surveys remain virtually unchanged from last week's near-all-time-high negativity. Again, as I said last week, individual surveys have seen more extreme readings, but when taken together we are seeing an almost unparalleled level of pessimism. The Market Vane survey slipped another percent to 17% bulls, which is the second-lowest reading in the past 20 years. The Consensus survey also dropped a percent to 22% bulls, which places it in the bottom 5% of bullishness. The Investor's Intelligence and AAII surveys showed a very slight uptick in their bullish ratios, although both are low and historically bullish at current levels. I've previously mentioned an index that I've created using stochastics of the four major surveys, and that has hit a new all-time low with this week's readings. Although we are seeing an extreme confluence of negativity in these readings, we have not yet seen the persistence that many of the past bear market bottoms have seen. I mentioned before that the II survey has spent months on end in an inverted state, where bears outnumbered bulls. Whether the investment landscape has changed so much as to render a duplication less likely is debatable, but we have to consider the possibility that this bear market will persist for much longer and we will see not only unprecedented levels of pessimism, but also an unprecedented duration of pessimism. I don't believe that's likely, but it is something to consider.

AIM - Not much to add here, as the model ticked down just a hair to 99.4 from 99.7 last week. The four-week moving average has now hit the second-highest level of all time, second only to May of 1994.

STEM - We continue to see extreme levels of fear on a short-term basis, which is keeping the moving averages on this model elevated above the buy threshold. To get an even longer-term view of this, I have included a 10-day moving average of the model itself. You'll recall that the signal line on the model is the 50-period moving average (just under 4 days), so this would be the equivalent of a 130-period moving average. The point is simply to give a bigger-picture view of our short-term sentiment gauges. It has now hit a new high from the inception of the model.

BREADTH RATIOS - We are now in the cooling-off stage from the overheated selloff over the past couple of weeks that brought our breadth measures to historic extremes. The advance/decline, new high/new low and TICK indicators are now in the process of righting themselves and working back towards their mean values. It will be a fairly quick process, as the a/d line will be dropping large negative readings every day. So any rally continuation with positive breadth will take us from "maximum" oversold to neutral to overbought possibly within one week. These overbought readings after such oversold conditions do NOT usually lead to declines, but rather a churning process while the market digests the volatility. The new high/new low ratio will probably take more time to reach a neutral state, and even longer to reach anything close to overbought. The cumulative TICK indicators, particularly the intraday ones of course, could reach overbought very quickly. In fact, the intraday indicators are almost there now. However, if (IF!) this is the beginning of a new trend, these intraday indicators will throw off one false overbought signal after another, so we will have to be careful about that.

CBOE RATIOS - There continues to not be much change here, as the open interest ratio, open interest - p/c spread and OEX p/c - total p/c spread stay at or near all-time bullish extremes. The total put/call ratio has calmed down a bit, and the longer-term moving averages are beginning their slow descent back to the mean. In the S&P 500 options, there was not much action on Friday, as the decreased volume on the stock exchanges carried over into the options. In fact, volume in these options on Friday was about half of what it was earlier in the week. There did not seem to be any particular bias to buying or selling puts or calls. The bid/ask ratios on these options continued to be an excellent guide on Friday, as I had mentioned on Thursday that we were seeing a huge amount of put selling by the institutions. These companies are masters of this particular game, and they rarely lose big. I will continue to monitor this action on a more regular basis than I have been to see if they can continue to give us an edge. If so, I will include it in the regular nightly updates and indicator sections.

VIX and VXN - The deflation of the VIX from the spike highs is carrying it down close to the -10% band that I watch carefully, although I'm not paying particularly close attention to it at this point. It's clear that the market is not in a trading range, so this aspect of the indicator becomes less effective (it's extremely effective when we enter a trading range). I would expect the VIX to hiccup its way down to a longer-term average of around 26 or so before I seriously consider the 10% bands again. The VXN is more interesting, as it made a new high and reversal on Friday. Just as in stock prices, these patterns often lead to short-term reversals in trend, which would be forecasting a further move down in the VXN and up in the Nasdaq 100. I have found this to be a consistent pattern.

BEARISH

COT - There was a slight improvement in this series this week, but still nowhere near what I would prefer to see near a market bottom. The commercials added 17,000 long contracts while also adding 7,500 short contracts for a net subtraction of about 9,500 contracts from their net short position. The small specs added 9,300 long contracts and also added 6,500 short contracts for a net addition of about 2,800 contracts to their net long position. Although generally a positive development, it's certainly nothing to get excited about. In fact, it's quite worrisome. I would really be expecting the commercials to be covering a much larger number of short contracts at this point if they were indeed counting on a sustained change in trend. The fact that they have not yet made that commitment makes me wonder about the longer-term prospects for a major bottom in here.

NEUTRAL

TRIN - The fairly narrow breadth recently and tremendous volume has caused severe swings in this indicator, as the switch of just a couple of high volume stocks from negative to positive or vice versa will make the TRIN go from one extreme to another within the matter of a few seconds. There hasn't been any sustained trend in this indicator recently and it's just sitting in neutral.

STEM.MR - When this model jumps around without hitting one extreme or the other, you can be pretty sure that the market has not gone anywhere fast. When it coils up like it is doing now, you will usually find inside days and triangle patterns on the charts, which are typically preludes to big moves in either direction. We have that situation now, as this model hasn't hit either extreme for a couple of days as the market digests the gains from Wednesday's reversal. Once the markets break out of this short-term congestion, the odds of a trend are extremely high, and although I will issue whatever signals are generated, I would be extremely hesitant about fighting any short-term trends that develop next week. As I mentioned above, the situation is even more clear on the Nasdaq, as a break of Wednesday's high or low should determine the trend for the next week or two at the very least. Those levels will be widely watched and extremely important.

I began suggesting a couple of weeks ago that we should see an increase in volatility. I would say that certainly has been the case, and now (if history is any guide), we should be winding down the volatility. This does NOT mean that there won't be days of 30+ point ranges on the S&P, but it does mean that they will become less frequent. How the market respond to the economic news next week will be very important. It was able to perform very well late in the week with all of the negative news that was thrown at it, and any continuation of such will give many traders and - perhaps more importantly - investors the confidence to once again buy shares.

- Jason Goepfert