Jan 05, 2003

Sunday, January 5, 2003

Last week, there were some signs that a short-term upside reversal was getting increasingly likely. This week, we're approaching the opposite end of the spectrum.

Comment: For the first time since late November, the VIX has given a bearish combination of being stretched more than 10% from its 10-day average and an RSI reading of under 30. For those who are new, you can check the December 8th weekly commentary for five examples of why I find this setup effective. While not a precise timing mechanism, we very often find a short-term top when we see this oversold combo (meaning the VIX is oversold and equities are overbought). If you refer back to last week's commentary, you will see that I presented a chart of NYSE volume. More specifically, it is the deviation of the 10-day average from the 200-day average, and is an intermediate-term way to observe volume patterns. As of last week, we were low but not quite extreme. That has now changed, as our current reading of minus 21% (meaning the 10-day average is 21% below the 200-day average) is the lowest since August 1996. This suggests a serious lack of interest or too much complacency, and as you can see from the chart, such situations have lead to lower prices in the ensuing few weeks every time during this bear market. In addition, the S&P 500 and TICK ranges continue to remain near the bottom of their ranges.

Bottom Line: High volatility is commonly present near market low points, while low volatility is often a precursor to a top. That pattern has played out with high probability during over the past two years, and we have that situation now. This suggests that there is an excessive lack of fear of lower prices over the short- and intermediate-term, which in turn suggests that lower prices are more likely than substantially higher ones.

Comment: Last week, I said that a breach of the upper trading band by the 10-day TRIN would be a significant positive in the short-term, especially considering that it would occur in the month of December (see last week's commentary for the statistics on such an event). We did breach that level on Tuesday, with the 10-day TRIN hitting 1.58. Obviously, Thursday's rise was much larger than could have been reasonably expected, but the overall positive bias should not be a surprise. After 5 and 10 days the market was still higher more than 70% of the time when the reading occurred in December, so that gives some hope that the recent gains may mostly hold. Going counter to this is the fact that Thursday's closing TRIN reading was the second-lowest in five years (the lowest being a .22 reading on October 28th - the reversal session after a 7% one-day plunge in the S&P). It was the 7th-lowest reading in the past 40 years. The table below summarizes the S&P 500 performance the given number of days after the 10 lowest closing TRIN readings over the past 5 years.

This is a bit deceiving, however, since 9 of the 10 readings occurred after the bear market began in March 2000 (another example of bear-market rallies being explosive). So if we go back over the past 40 years and look at the bottom 10 readings, the market performance was much, much better:

Nine of these 10 readings occurred since the mega-bull began in 1982. Obviously, the huge performance gap between the two table is reflective of market performance during the lookback period. However, Thursday's explosive move occurred on less-than-average volume (less-than-average being defined as less than the 200-day average). If we go back over the past 40 years once again and look at the lowest 10 TRIN readings which occurred on below-average volume, then the results change considerably from the table above:

We can see that if the TRIN thrust occurred on below-average volume, the results are not nearly as positive as those which occurred on above-average volume. So the fact that Thursday's reading was accompanied by below-average volume, in the context of a bear market, argues that it is a bearish development.

Bottom Line: The current readings here are somewhat mixed - we have recently had a high 10-day TRIN reading, which is bullish, but more recently had an extremely low one-day TRIN reading on low volume, which is bearish. Since overbought readings in a downtrend are more effective than oversold readings, I would have to say that the overall impression from this indicator is bearish.

Comment: Last week, our shortest-term model was the most positive it had been in over a month. This week, we have the exact opposite situation, as I laid out in the model change on Thursday. The chart below shows the top and bottom 2% of model readings during 2002:

It should be clear why I don't consider it wise to trade off of these model extremes alone. The model would have had you buying well before the ultimate low in July, and a few other buys were quite early as well. However, when you combine the model with a price trigger (e.g. only buy when price exceeds the prior day's high, and/or only take trades in the direction of the larger trend), performance improves considerably. As of this weekend, we just saw a reading in the bottom 2% on Thursday (which continued into Friday morning). Price is currently hovering right around a flat 50-day moving average, and we haven't yet exceeded a prior day's low since the signal was given. Therefore, if I were giving trading recommendations, we would not yet be at a "sell". Since Friday's low coincides with the 50-day average in the S&P, if we traded below that level, I would concentrate heavily on short setups.

Bottom Line: If the S&P trades below the 902 level early next week, history suggests that would be a high-probability time to concentrate on setups that profit in declining markets.

Comment: We've had positive seasonality for the past couple of weeks, and it hasn't done us a whole lot of good (consistently, anyway). This week things change a bit, as the end-of-year and beginning-of-new-year positive biases disappear. From the Daily Market Bias section of the site, we can see that January 7th, 8th and 9th appear to have an overall negative bias. Here are the stats:

	Average January Day	January 7th	January 8th	January 9th
Avg Return	0.07%	(0.04%)	(0.33%)	(0.22%)
% Positive	55%	42%	39%	47%
Maximum	5.0%	2.7%	2.0%	1.6%
Minimum	(3.8%)	(2.2%)	(2.7%)	(3.0%)

Bottom Line: The real strong positive seasonality that was with us the past couple of weeks is gone. If anything, the coming week has a slightly negative bias.

Comment: Due to the holiday week, the CFTC will not release this data until Monday, January 6th.

Comment: The bullishness exhibited by the Investor's Intelligence survey respondents continues to hang around, as I discussed earlier this week. The lowrisk.com survey shows a similar amount of bullishness, with a four-week moving average sitting on the upper end of neutral at 44% (50% could be considered overbought). However, at least one of the other surveys is finally beginning to reflect the market conditions that we have experienced over the past few weeks. For the first time since early October, the AAII survey showed more bears than bulls, with a bullish ratio of 46% (anything under 50% shows more bears than bulls). I prefer to follow this survey's bullish ratio on a four-week moving average basis, and after giving a good "sell" signal at 71% in late November / early December, this average has declined sharply to 56% (anything under 50% could be considered oversold). I have seen some recent attempts to explain away some of the surveys, suggesting that the respondents didn't properly reflect the makeup of current market participants, whatever that means. In my experience, all of these surveys are very effective over time. The individuals who respond to these surveys may be fairly sophisticated individually, but taken as a group, they invariably exhibit the same kind of "group think" and mass psychology that they always have. The majority of traders tend to be wrong over time, in both opinion and positions, and I believe all of these surveys continue to provide us an invaluable service.

Bottom Line: We're seeing a fairly wide difference between some of the sentiment surveys, but as a whole they remain much too bullish to suggest that any bounce here would be anything but short-lived.

Comment: Since the Market Vane bullish percentage figure was not available by the time this commentary was written, the AIM model has not been updated.

Comment: Last week, I said that although the asset flows here looked constructive, we hadn't yet seen a sudden shift in assets that would make me feel more comfortable in expecting an upside reversal. That changed on Tuesday, as our shortest-term indicator here (the 3-day RSI spread between the bullish and bearish ratios) hit the extreme threshold of -60. Not surprisingly, the action on Thursday and Friday erased that extreme, and we are now neutral with a reading of +18 in that indicator. Longer-term, the 3-month stochastic remains in neutral territory. The moving average deviations never quite made it to their extreme thresholds. Actually, the bullish flow did get quite extreme (meaning there was a sustained move out of the bullish funds) but the bearish flow did not. What this tells me is that in late November, there was a large and sustained shift of assets out of the bearish funds and into the bullish funds. Obviously, this reached an extreme and the recent month-long decline was the result. While prices were declining, these traders gradually moved out of the bullish funds but didn't put them into the bearish funds with as much gusto. We can see that the money market levels have been rising ever since December 2nd, so apparently some of that money from the bullish funds was put there. So instead of changing their outlook from extremely bullish to extremely bearish (which from a contrary point of view would be bullish to us), they moved a large part of their assets to the money market, thus effectively becoming neutral to moderately bearish instead of extremely bearish. In order to be comfortable with an intermediate-term low point, I would have much preferred to see a larger amount of assets being put into the bearish funds by these traders who are consistently late in recognizing a trend.

Bottom Line: The short-term shift of assets in this mutual fund family was bullish as of Tuesday's close, but that has now changed to neutral. The longer-term outlook is neutral to modestly bullish, but we didn't quite see the extremes we "should" have in order to suggest that these traders have shifted their momentum into betting on lower prices to an extreme degree (which would be bullish to us).

Comment: Since late October, this model hasn't moved more than 8% away from its average value of 47%, which I guess is fine considering the magnitude of moves the S&P has made in that span of time. A few subscribers have asked me that since the model went into strong positive territory in October, wouldn't that "signal" still be in effect since it has not yet reached the opposite extreme? Normally, I would say "yes", but I think the longer-term trend must be accounted for and is the overriding factor. A buy signal in a downtrend is only good for an intermediate-term snapback rally, and I don't necessarily think the model needs to reach an overbought extreme before considering the buy signal negated. However, if we do get a sell signal (by the model reaching its lower trading band), then I would consider that to be in effect until a true extreme is reached in the opposite direction.

Bottom Line: Same story here as over the past two months - the extreme negativity we saw at the October low is gone, and due to the clear downtrend we are in, that means we must wait for another true extreme before considering the model to be positive.

Comment: On Friday, we dropped the high readings we had recorded earlier in the week, so the model fell 6% in just one day. This has put it within 3% of its lower trading band, and at the lowest absolute level since early and late November, late August and early March. While there is still a bit of room to go here before I would consider it outright bearish, we're beginning to enter dangerously low territory. We have 8 more relatively high readings that we'll be dropping over the next 8 half-hourly periods, so if we have another rally day on Monday, it's likely we'll drop past the lower trading band.

Bottom Line: If we drop a few more percent here, I would be very wary of a probable downside reversal over the short-term.

Comment: One of my favorite ways to look at the put/call ratios is to look at current open interest in the OEX options (open interest tracks the total number of contracts still open in each option series). As you know, I view the OEX options in a non-contrarian way. Whether it's because the option premiums are higher, or they have tighter spreads or are more liquid or whatever, OEX options tend to attract a more sophisticated trader, and these traders often do quite well at major turning points. By observing the difference in open interest between OEX puts and OEX calls, we can see where these traders are accumulating their bets. If put open interest RISES in comparison to call open interest, then that's bearish. If put open interest FALLS in comparison to call open interest, then that's bullish. Obviously, expiration plays a large role once a month in affecting each series, but not necessarily the ratio between the two (since many positions are opened in back-month options that haven't expired). Normally, the day following expiration shows total open interest (puts and calls) about 45% of what it was before expiration. After the most recent expiration on December 21st, open interest dropped to only 36% of what it was prior. This was the biggest drop in nearly two years, so I thought it would be especially interesting to see how OEX traders began building up their positions again. Since the December expiration, they've opened 39,360 put contracts as opposed to 28,675 call contracts, which has pushed the ratio between put and call open interest to the highest level since March. The chart below is a 5-day moving average of this ratio, and shows that high open interest ratios have typically not been kind to the market over the past couple of years.

While the current ratio isn't yet extreme, it has been climbing steadily over the past week. At the same time, the equity put/call ratio has been falling steadily, suggesting the more poorly-capitalized traders are beginning to bet more heavily on the upside. The 10-day ratio has fallen from a peak of .73 a couple of weeks ago to .62 now. Once again, this is not yet extreme, but it bears watching - especially in combination with rising OEX put open interest.

Bottom Line: Rising levels of OEX put open interest (compared to call open interest) and falling equity put/call ratios is not encouraging. While these levels are not yet extreme, the trend is troublesome and another week or so of this continued trend will spell trouble for equities.

Comment: The 10-day advance/decline line is now the highest it has been since early December, at .56 (meaning that advancing issues on the NYSE have averaged 56% of all up or down issues over the past 10-days). This is over the .55 overbought threshold and close to the .60 "maximum" overbought reading. It would take another day like Thursday in order for us to reach that .60 level on Monday. More likely, we'll chop around this level for awhile (unless we sell off hard) since for the coming week we'll be dropping one large positive reading, and several smaller positive and negative ones. The daily cumulative TICKS are neutral on the NYSE and Nasdaq, although the NYSE intraday indicator is still seriously overbought. It is certainly possible for this indicator to work off its overbought condition by the market going sideways for a day or two or even rising slightly, but it's not likely. I pointed out in the intraday comments last week that a combination of an extremely overbought cumulative TICK and overbought price oscillator has only occurred within a few days of short- to intermediate-term tops over the past couple of years (with one exception after the market re-opened in September 2001), so a continued rising market over the next week would be extremely unusual. Our Down Pressure indicators are also reaching overbought territory, with the S&P at 32% and NDX at 31%. One more solid up day would likely push both of these firmly into overbought as well. Other than after power thrusts off major panic lows, when these indicators reach overbought, a high has been soon to follow.

Bottom Line: Overall, we're mildly overbought in our breadth measurements. There is more room to go before I would consider this complex as a whole to be bearish, but another few days of generally rising prices would likely push us into an area where further gains would be highly unlikely.

Comment: For the second week in a row, there was essentially no change in the NYSE short sales data. This is not so much of a surprise considering the reporting period was relatively flat. This data remains neutral.

Bottom Line: Until we see some movement in the ratio of short sales between specialists and the public, I don't believe there's much to read into this data.

Last week, I said that we were seeing signs that short-term pessimism was getting to an extreme, so I would look to the long side at the first sign of a price recovery. I also said that a 5%-8% rally would likely set up an intermediate-term shorting opportunity. We've rallied about 4% for the week, so I think it's still viable that another few percent would set up those shorts. We're already at a point sentiment-wise where I would prefer to focus on the short side, but another couple of percent on the upside would in all likelihood make me quite aggressive. Most of our indicators and models are neutral, but another little push will tip many of them into bearish territory. Whenever I see several bearish indications, a few neutral, and no bullish in the context of a long-term downtrend, I believe the odds are heavily in favor of short positions vs. long. We have that condition to some degree now, but as I said another little push up would set us up nicely.

This disclosure is not intended as trading advice in any form. It is meant as a note to subscribers that I have a position directly affected by my market outlook. Although I take great pains to remain objective in my commentaries, I believe it is only fair that readers should know that I have taken positions in accordance with my market outlook.

BOTTOM 10 TRIN READINGS - SINCE 1997
	1 DAY	3 DAYS	5 DAYS	10 DAYS	30 DAYS
Avg Return	(0.40%)	(0.30%)	(0.20%)	(3.0%)	(3.2%)
% Positive	27%	40%	40%	40%	30%

BOTTOM 10 TRIN READINGS - SINCE 1963
	1 DAY	3 DAYS	5 DAYS	10 DAYS	30 DAYS
Avg Return	1.51%	1.64%	1.46%	2.63%	2.63%
% Positive	60%	80%	80%	80%	70%

BOTTOM 10 TRIN READINGS ON LOW VOLUME - SINCE 1963
	1 DAY	3 DAYS	5 DAYS	10 DAYS	30 DAYS
Avg Return	(0.08%)	(0.46%)	(0.35%)	(0.53%)	2.09%
% Positive	40%	60%	70%	60%	60%