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Sunday, August 4, 2002

From last week's commentary:

"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."

The NDX exploded for a 9% gain in two days out of that condition I mentioned last week.  These coils are some of the most effective patterns available, and I suggest that you print out a daily chart of the NDX and circle 7/24, 7/25 and 7/26.  When you combine that pattern with a sentiment extreme, the odds are extremely high for short-term profit.  In order to keep that profit, however, you needed to tighten stops on any long positions, and hopefully you did so when short-term sentiment became less conducive to further gains.

As of this weekend, all models have again cycled back to oversold, with two of them in STRONG POSITIVE territory.  This will have me on the lookout for upside reversals beginning Monday.

Indicator Summary:

BULLISH

NYSE MEMBERS REPORT - I mentioned previously that I would be very interested in this week's figure due to the dramatic decline during the reporting period.  At 35%, the ratio didn't drop as much as I thought it would (from 38% last week).  If you didn't read last week's commentary, I refer you back to the table of past Specialist Short Ratios.  That table showed that from 1941-1975, the average one-year return after a reading of 35% was 23.9% with a 94% probability of rising prices.  From 1976-2001, the average one-year return was 20.6%, again with a 94% probability of rising prices.  This type of reading has historically been an excellent long-term buy signal, and we've gotten an abundance of them over the past few weeks.  I mentioned last week about the bias toward lower Specialist Short Ratio readings due to various factors, and indeed the latest reporting period showed an all-time record for number of shares shorted by the public.  Although the ratio of public/member shorting did not reach a record, it is still extremely high historically.

COMPOSITE MODEL - After dropping down to 63% earlier this week, the past few days have caused the model to ratchet higher once again, finally closing with a STRONG POSITIVE bias at 77% on Friday.  The main cause of the increase was the heightened volatility as measured by the VIX, which rose dramatically on Thursday and Friday.  Offsetting that somewhat was the less-oversold readings from the a/d line, which  continues to drop one large negative reading after another, although that will cease by Tuesday. 

SENTIMENT SURVEYS - The historical confluence of negativity we've seen over the past two weeks has been alleviated somewhat due to the strong rebound off the recent lows.  All of the major surveys showed an increase in bullishness in the latest reporting period, which should be expected given market performance during that time.  None of the increases were particularly alarming.  If we assume that most of those surveyed take positions in accordance with their stated views on market direction, we can then assume that the average cost basis for those new long positions is around 832 on the S&P (using the average of open, high, low and close during the reporting period).  Granted, those are two very big assumptions, but it gives me a reference level to observe.  If we stay above that level, most of those new longs will be above water and may add to their bullish positions.  A move below that level may bring about increased selling pressure as those who bought around that average price will try to get out at even and those below will want to preserve something of a profit in case the recent lows do not hold.

AIM - After spending an unheard-of two straight weeks above 99, this model has settled down somewhat to a reading of 86.4, which is still above the buy threshold but drops the model to a POSITIVE bias.  We've now had 9 straight weekly readings above 80, which is surpassed only by the 22 straight weeks (!) during the summer of 1994.

STEM - This intermediate-term model moved to a POSITIVE bias on the close Friday, as the optimism after the rally off the lows quickly dissipated.  The short-term sentiment measures which make up this model cycled from extreme optimism to extreme pessimism in the span of two days, which is quite amazing.  Apparently there are a lot of traders who believe the market should go up every day.  The 20-period moving average has moved back up to the highest reading the model has seen over the past month, next to the panic readings at the recent low.

STEM.MR  - With a STRONG POSITIVE bias as of Friday's close, this short-term model is suggesting that sentiment has swung back from overbought and a strong negative reading on the 30th back down to oversold.  All components at this time are in oversold territory.  Considering that the 10-day moving average of the VIX is over 42, it takes quite a bit to get VIX.MR into buy territory.

BREADTH RATIOS - On Tuesday, the advance/decline line 10-day moving average will drop the last of the large negative readings which has caused this oscillator to rise even while the market dropped over the past couple of days.  On Monday, we will drop a reading of -1999 and Tuesday we will get rid of -2131.  After that, we will be dropping a string of large positive readings, which will cause the oscillator to drop (provided they're not replaced by even larger positive readings) and cycle back down to oversold.  We could reach another oversold reading by the time the week's up if we have even moderate a/d numbers.  After reaching historical overbought readings early last week, the intraday cumulative TICK indicators have dropped back down to oversold, although they're not nearly as oversold as they were during the height of the panic selling.  If we put in a higher low on the 30-minute charts, I will place more significance on these readings as they would then be oversold within an uptrend, when they are most effective.

VIX and VXN - After one of the largest weekly deflations in history, the VIX reversed course and completed one of the larger weekly rises in its history.  I mentioned on Thursday that the 6-point rise in the VIX, while normally bullish, put me on guard for a possible large adverse move, and that proved to be somewhat the case on Friday.  The VIX increased 8 points low-high on Friday before a late-day collapse.  The weekly rise in the VIX we just saw has been matched or exceeded 9 distinct times in its history, leading to substantial short-term outperformance in the S&P.  There have been 40 days included in those 9 distinct occurrences.  The S&P has averaged a 2.1% return 5 days later (with the market higher 68% of the time) and a 3.3% return 10 days later (with the market higher 78% of the time).  The 10-day moving average of the VIX has been higher only twice in its history - the bottom in 1987 and the bottom in 1998.  This large rise in volatility should have us on the lookout for another reversal to the upside, although caution is warranted whenever volatility shows such a short-term spike.

NEUTRAL

TRIN - The 10-day moving average of the TRIN is still sitting in neutral territory, as we've seen a daily fluctuation between overbought and oversold which cancel each other out.  We'll be dropping two extremely low readings next week, which should prop up the moving average if we continue to sell off over the next few days.  This indicator is not telling us much at this point, and in fact has done a poor job during this selloff.

COT - We had another improvement in the S&P 500 futures positions this week, with the commercials reducing their net short position by over 13,500 contracts while the small specs decreased their net long position by over 6,500 contracts.  These position changes are somewhat surprising considering the market action during the reporting period.  We would typically see the commercials reduce their short positions during a falling market, not a rising market, and the small specs would normally add to their net long positions during such a rise.  This move has improved the one-year and three-month stochastics considerably.  Longer-term, we are not seeing the liquidation of commercial short positions or reduction of small spec long positions that has led to market outperformance in the past.  The intermediate-term picture here is neutral to moderately bullish while the longer-term picture remains quite bearish.

PUT/CALL RATIOS -  With the rally off the lows, we began to see earnest call buying by the masses really for the first time in two months.  I pointed out in the daily commentary that the 3-day moving average of the one-year total p/c rank reached the lowest point since the May peak, and that turned out to be the top once again.  On Friday, the total p/c ratio reached .93, so the eager call-buying subsided somewhat.  However, we're also seeing an increase in put buying by the smarter-monied OEX options traders (smarter-monied is open to interpretation).  The OEX p/c ratio has had consecutive readings above 1.0 for the first time since the last failed rally peak on July 8th.  I don't believe the high p/c ratio is due to selling puts (which would be bullish) since OEX options are American-style (can be exercised anytime) and lead to unpredictable risk for options sellers.  Conflicting with that bearish interpretation is the data from the S&P 500 options pit, where we have the highest put/call bid/ask bias ratio since right before the big rally on the 24th.  The ratio reached 7.30 on Friday, which shows a significant institutional bias towards selling puts AND buying calls.  There were particular biases towards buying August calls and selling September puts.  The most remarkable trade was a 3,850 contract purchase of the August 885 calls (a $6.5 million bet that the S&P closes above 902 (885 + 17 in premium) by August 16th).  It would be unusual for an institution to outright purchase such out-of-the-money calls with such a limited time to expiration, so either someone is really bullish (unlikely) or they are closing out an existing short position (more likely) or they created some type of spread (most likely although I don't see any evidence of it).  In any event, the fact that the bid/ask bias ratio is so skewed tells me that the institutions are not betting on a collapse from here, but rather something of a rally, which is certainly bullish.  With so many crosscurrents in these ratios at the moment, I would have to rate the complex as a whole as neutral.

We now have a situation whereby all four sentiment models are in positive or strong positive territory, and when that happens I begin to look aggressively for trades on the long side.  The fact that the volatility measures are so jumpy and make sudden one-day moves has put me on guard more than usual, however, and any long-side trades I decide to take will have tighter-than-normal stops underneath.  Although the spikes in the VIX and VXN are longer-term positives for the market and have been exceptional buy signals in the past, they have also preceded some of the most wicked short-term declines in the market averages.  This fact alone requires that I await more confirmation than I normally would before taking a trade.

 - Jason Goepfert