Mar 02, 2003

Sunday, March 2, 2003

On an administrative note first of all, I have received quite a bit of feedback from subscribers about the changed Indicator page(s). By far, the biggest issue was the fact that you now have to toggle between two different pages in order to quickly see both the current value and whether the indicators are bullish or bearish. In an effort to address that, and add some functionality at the same time, I have created a new page, an example of which is at the link below:

Please take the time to review this page, and get back to me with your feedback. On this page, you can actually sort all of the indicators by all of the categories, such as name, category (e.g. volatility, breadth, etc.), term (e.g. short- or intermediate-term), and date of update. Simply click on the column title, and the table will re-sort based on that column. Perhaps the most useful feature of this way of doing it is that you can sort by what indicators are bullish, bearish or neutral. By clicking on the "BULL" column, for example, you will be presented with the indicators which are most bullish at the top of the page. If you then click "BEAR", you will get the most bearish indicators at the top. Personally, I think the page would be a great help, but I need your feedback to determine whether to add it to the site. If I do, the current indicator pages would go away and be replaced by this one. Please note that the link above is for an example page only, and does not necessarily contain updated information. The x's in the bull, neutral and bear columns are NOT accurate.

In the weekly commentary two weeks ago, I stated that I believed a steady rise from that level (S&P 835) was unlikely, unhealthy and would most likely fail. In fact, I said that I would be looking to short much more upside, which we did in the model portfolio. That rally did indeed fail, and carried us down to retest (?) the low put in on February 13th. The action during these two weeks has not changed our overall sentiment condition very much, and in fact in the short-term were facing a similar situation to what we saw in the last weekly commentary.

Comment: For the second week in a row, the Specialist Short Ratio came in at a low reading of 32% (meaning that specialists on the NYSE accounting for 32% of short activity on the NYSE for the week ended 2/14/03). As you can see from the site, this reading is more than 2 standard deviations from the bear market mean, which is notable. Not only is the ratio itself in bullish territory, but so is the "de-trended" ratio. This is simply a way of saying that any long-term trends in the data have been accounted for. Since there has been a secular downward trend in the Specialist Short Ratio, it is necessary to find a way to cancel that out if one is to compare recent history to historical precedents. I have chosen to do this by looking at the ratio in terms of the 4-week average divided by the 26-week average. This puts the most recent month's activity in the context of the last six months. When this "de-trended" figure is high, then there has been a high amount of specialist shorting, and that's bearish. When the ratio is low, then the public has been the short-side aggressors, and from a contrarian standpoint that's bullish. Currently, this figure stands at .88, which means that the activity during the last four weeks is about 88% of what it has averaged over the past six months. This much of a stretch is also almost 2 standard deviations away from its mean and is the lowest since 1996, except for a very brief dip after the shock of 9/11. The recent weekly figures and shorter-term moving averages are all in bullish territory and suggest that we have seen enough of a push in shorting by the public that a substantial rise from here could be supported.

Bottom Line: The substantial and sustained public short selling we have seen from late January through mid-February is notable. It is extreme, not only in the context of recent history, but also since 1943 on a relative basis. All of the statistics and various ways of making indicators from this data are only meant to uncover the probable answer to one question - how extreme are we? The answer we're getting now is "very", and that provides a significant amount of support to this market.

Comment: The first few trading days in March have historically been quite market-positive. In addition, March is the third-best month for the market in terms of expectancy (i.e. (probability of gain * average gain) - (probability of loss * average loss)). The expectancy is 2.84%, meaning we should expect to earn $284 for every $10,000 invested over time if we buy the S&P at the close on the last day of February and sell it on the close the last day in March. While I would never recommend someone do that, it does tell us that overall March has been a fairly positive month historically.

Bottom Line: The typical beginning-of-month positive bias is in effect for the first few days this week, along with the positive influence that March normally has overall.

Comment: Not much change here, in either the full contract or the e-mini. In the large contract, the commercials increased their net shorts by a very small 200 contracts, while the small speculators increased their net longs by just over 2,300 contracts. The overall balance between the two remains neutral, as can be seen from the Futures Balance Matrix on the site. For a reporting period that was down only slightly, the changes are not out of the ordinary. In the e-mini, the commercials increased their net longs by just under 1,300 contracts, while the small specs liquidated a large number of total contracts and adjusted their overall position by reducing their net short by just over 9,700 contracts. In general, the commercial and small spec positioning in the e-mini appears positive as the commercials still have a relatively large net long position while the small specs are leaning fairly heavily on the short side (as of last Tuesday, anyway). As I've said several times in the past few weeks, however, I want to make clear that although the e-mini positioning has given decent clues as to future market action recently, the long-term forecasting record of this contract is dubious, and I continue to believe that should be taken into consideration.

Bottom Line: Overall, I would view this data as more bullish than neutral, but only slightly. In looking at the recent forecasting accuracy of the large vs. small contract, the tip of hat certainly goes to the small contract, and the indications there remain bullish.

Comment: There has been quite a bit of talk lately about the Investor's Intelligence numbers, and how they are beginning to move in the right direction. That's true, but I believe the operative word here is "beginning", as we are not yet comparable to readings seen at past major lows. Consider the following table, which looks at II readings at each major low since 1996:

LOW	BULLS	BEARS	BULL RATIO	4-WK MA
Jul. '96	43	42	51	55
Mar. '97	40	38	51	58
Sep. '98	36	47	44	47
Oct. '99	39	38	51	55
Apr. '01	45	43	51	55
Sep. '01	34	42	45	51
Jul. '02	35	40	47	52
Oct. '02	28	43	40	47

Average	38	41	47	52

Current	40	36	53	57
Are we more/less bullish than avg?	MORE	MORE	MORE	MORE

We can clearly see that overall, the survey is currently showing more optimism than the average low. Not only that, we have less bears now than at any other major low, a higher bull ratio, and a higher 4-week moving average of that bull ratio (except for one other instance). I think the most telling figure here is the number of bears. The way the survey is constructed, the bullish number is somewhat skewed. While I only include the "pure" bullish number in my readings, in actuality one could also add the neutral camp to the bullish figure. That's because "neutral" as far as Chartcraft is concerned (Chartcraft is the company which administers the Investor's Intelligence survey) includes those who are generally bullish, but expecting a correction. They believe that after a brief dip, the markets will continue higher. But the bear camp is "pure", meaning those who are bearish clearly expect lower prices. So far the S&P has declined 46% from its all-time high, and 12% from the January high, yet we're still seeing less bears now than at any other major turning point.

One factor which may be coming into play here is the population of this survey - newsletter writers. Chartcraft tracks about 140 newsletter writers to come up with its bullish and bearish figures. I had a conversation with Ike Iossif of Aegean Capital Management a few weeks ago and we had an interesting discussion about this. He informed me that he was approached by a very large publisher of investment newsletters some time ago. This publisher told Ike that when his newsletter published reports which were negative on the market, his subscription base declined. However, when he published bullish reports, his business picked up considerably. So, he switched the focus of his newsletters to long-only, and his business took off. While the story is rather amusing to me, I think it points out a problem inherent to this particular survey population. Newsletter writers, even during a severe bear market, tend to acquire more subscribers when they have a bullish outlook than when they have a bearish one. That may be a contributing factor to why we only rarely see the bear camp greater than the bull camp anymore, and even then just for a week or two, as the newsletter writers are quick to shift to a bullish focus once an apparent low has been put in. With the current low level of bearishness among these newsletters, and by extension the investor population in general, it would be unusual to see a major low here.

The other sentiment surveys didn't change much from where they were last week, or even two weeks ago for that matter. They are showing the minimum amount of bearishness we would want to see if looking for a low sometime soon. The one exception is the AAII survey which has actually reached extreme levels.

Bottom Line: Overall, the sentiment surveys are showing a level of bearishness which could support a rally from these levels. However, only the AAII survey is truly extreme, and the others have shown only a minimal amount of pessimism. The II survey, which is certainly the most widely followed, has been the most reluctant to become bearish and has not yet reached a point that has appeared at almost every other major low.

Comment: Two weeks ago, I stated that every time this model has formed a peak above 65%, it has corresponded to a very tradable market low. We have accomplished that this week, as the model reached 65.5% last week and dropped just a tad to 65.3% this week - officially creating a "peak" in the model. There is a danger that we could have something like July, where the model peaked around 64% before reversing again to reach new highs. In any event, the model is telling us that the momentum of the surveys is certainly skewed heavily to the bearish camp, even if the absolute levels of the surveys themselves are not all extreme. This type of popular negativity has always - always - lead to a tradable low. While the timing may not be exact, this tells us that lower prices are buying opportunities for those with a longer-term time horizon.

Bottom Line: The AIM model has reached a peak at a level that has corresponded to major lows in the past. This tells us that should we fail in here and reach lower prices, longer-term traders will want to use that opportunity to pick up shares. However, we may not get those lower prices, as we have seen enough negative momentum overall to support a rally at any time.

Comment: Two weeks ago, I highlighted the 21-day averages of the up issues ratio (aka advance/decline line) and the up volume ratio. At that point, they were near historical extremes, which boded well for some type of relief rally. The 10-day averages never made it to an historical extreme, which simply pointed out the fact that the market had suffered through slow, persistent selling with no panic-type climaxes. Currently, the 21-day averages have relieved their oversold conditions and are back to neutral, while the 10-day averages have actually made it quite close to overbought. It will be difficult for these indicators to actually reach overbought territory this week, however, as we'll be dropping three rather large positive readings and only two relatively minor negative readings from the averages this week. This means that as these figures drop off, we would need to see even larger readings replace them in order for the 10-day averages to rise meaningfully. While I prefer to see extremes here before reading too much into their meaning, I do believe the fact that these breadth measurements are close to overbought while the major averages have not even been able to make a higher high on the daily charts is not positive.

Two weeks ago, I suggested that we should look for new lows to expand to around the 600 level to rate the current market comparable to past intermediate-term lows, but we still have not seen a figure greater than the 219 we saw a couple of weeks ago. This too argues that we have not seen the type of breadth action that normally causes investors to reach the panic stage of their selling activities.

In the daily commentary on February 18th, I pointed out the low (overbought) level of our Down Pressure indicators on the S&P 500 and Nasdaq 100. That condition was quickly worked off by the decline immediately afterward, and they actually became slightly oversold before the little rally to end this past week. That little rally, however, has brought with it some low Down Pressure readings. Since the indicator that's posted to the site is a 3-day average of the daily readings, and we had a very high (oversold) reading on Wednesday, Monday's action could have a huge impact on this indicator. For example, if we have a flattish market on Monday and get a Down Pressure reading of 50% or so in the S&P 500, then the 3-day average will drop to an overbought 31%. But if we get an up market, say of around 10-15 S&P points, along with a likely Down Pressure reading of around 20%, then the 3-day average will drop to approximately 20%. This is an unsustainable type of reading in such an environment as we have, and would only be "acceptable" if we were coming directly out of a panic-type low. This argues that higher prices should be sold, and not bought.

Also flirting with overbought levels are our cumulative TICKS. On a daily basis, the NYSE TICK is essentially in danger territory, while the Nasdaq reading is firmly there. I want to point out an interesting dichotomy here. This indicator is very simply constructed by taking the closing TICK reading each day and summing up the past 10 days' readings. Each day, the reading from 10 days ago is dropped off and the current day's reading is added (I'm aware this is not a true "cumulative" indicator). So as the days close negatively, and on high negative TICKS, the cumulative TICK indicators will drop, eventually becoming extreme and suggesting that the selling has been exhaustive. Every once in a while, though, we'll see a situation like now where the market has been generally declining, but the cumulative TICK has been rising. This suggests that even during a down market, the closes have been accompanied by high positive closing TICK values, which implies some last-minute buying pressure. The common wisdom is that the "smart money" trades during the last 1/2 hour of the day, so the high closing TICK would imply that this smart money is buying during the last minutes of trading. A similar thing happened in mid to late December, where the market was meandering lower while the daily TICK crept up to overbought, suggesting the smart money was buying the weak closes. When the indicator reached overbought, the market soon began the explosive rally in early January. These divergences are fairly rare, and have not happened enough times to really say with confidence that it's a meaningful situation, but I do think we need to be aware that this is an unusual occurrence. On a shorter time frame, the NYSE intraday cumulative TICK (based on 30-minute bars) is still working off the severe overbought condition it entered late Thursday / early Friday. These severe conditions almost never end well, unless we are coming off panic-type lows. Again, this suggests that rallies should be sold instead of bought.

The 10-day TRIN values on the NYSE and Nasdaq have been working off the oversold conditions they reached in early February, and are in fact now approaching overbought. Both indicators are quite close to touching their lower standard deviation bands, which has been a bad omen for the market during this bear. Really the only times it has been "acceptable" to have extended low TRIN readings is immediately after the recovery from a panic low, which is something we are lacking now.

Bottom Line: All oversold conditions here have been alleviated over the past week, and in fact we are approaching overbought on many of the indicators. There is certainly still room for the market to advance despite the nature of the indicators, but they are telling us that higher prices should be sold and not chased from the long side.

Comment: The heavy short-side betting we saw in this mutual fund complex a couple of weeks ago is gone. Well, the momentum is gone anyway, and not necessarily the assets themselves. What I mean is that these traders have not pulled a great deal of assets out of the bearish funds and replaced them with bullish funds, as is the usual pattern. While the money market has stayed relatively stable, the total assets in the stock index funds have declined, suggesting the traders are simply taking their money out of Rydex or putting them into sector funds. Interestingly, even though bonds are hitting new highs, the money is not going into the bond funds. It seems the money is just being pulled out and going elsewhere. I touched on this on the 20th, and said then that this could be either bullish or bearish, but my feeling is that it is moderately bullish. I still feel that way, although one aspect that is troubling is the current high level of the Beta Chase Index. You can get a complete background on this indicator on the site, but quickly it measures the momentum going into high-beta funds at Rydex as opposed to low-beta funds. High-beta funds exacerbate market movements (e.g. if the S&P rises by 1%, a fund with a beta of 2 would normally rise 2%), while low-beta funds do not show much correlation to the broader market. For example, the Precious Metals fund has a beta of 0.26, as gold and other precious metals do not often move along with equities. The Beta Chase Index shows us how much momentum the high-beta funds have versus the low-beta funds, so if the ratio is high, then assets are moving to the high-beta funds and out of the low-beta ones. Currently, the ratio is very high, and suggests that the Rydex traders are moving assets into those funds which are highly dependent on equities movements. They are not necessarily moving into the straight index funds, but instead funds like Electronics, which concentrates heavily in semiconductor stocks. Conversely, "safer" funds have seen steady or falling asset levels. This type of speculation is often seen near market peaks, and very rarely does the market make significant progress afterwards.

Bottom Line: While the apparent apathy with which the recent market action has been greeted by Rydex traders appears bullish on the surface, a troubling development is the high level of momentum of the high-beta Rydex funds. This type of activity is normally associated with market peaks, not market lows.

Comment: The extremes in the put/call ratio that have been a positive influence for the market over the past couple of weeks are gone. In fact, we've come a long ways in swinging the other direction. The chart of the equity put/call ratio posted to the site contains standard deviation bands around the bear market mean, but I want to show a little different view today.

This chart simply shows the trend of the 10-day equity p/c ratio over the past year. High ratios show heavy put volume relative to calls (and thus increased levels of uncertainty on the part of options traders) while low levels show heavy call volume relative to puts (and by extension, a high amount of optimism and confidence that prices will not drop significantly anytime soon). From a contrarian standoint, high pessimism usually precedes market lows while rampant optimism is a recipe for lower prices. There is a very clear upward trend to this data, as call volume continues to shrink (thus pushing the put/call ratio higher). If you had used instances where the ratio approached its upper trendline as a signal to begin looking for long candidates, and approaches to the lower trendline to signal sales or short sales, you could have done very well. The "buy" signal given a couple of weeks ago has not yet resulted in markedly higher prices, and now we're coming perilously close to the lower trendline. I am aware of the large QQQ trades which have taken place over the past few weeks, thus skewing the data, and I have not adjusted the data for those trades (nor will I).

At the same time the equity ratio has been declining, the OEX put/call ratio has been rising. OEX options traders have an abundantly better record at calling tops and bottoms than do their equity option-trading cousins, so we follow the OEX put/call ratios in a non-contrarian manner. Meaning, when the OEX p/c ratio is high (showing high put volume relative to calls), that is usually bearish for the market, while low OEX p/c ratios tend to be bullish. Currently, the 10-day OEX ratio is the highest it has been in a year, since the market peak in March 2002. This has caused the spread between the OEX and equity ratios to also expand to the widest it has been since that time. This is bearish. In the institutional playground - the SPX options - our put/call bid/ask bias ratio has dropped below 1.0, to currently read .85. This, too, is not positive as it shows institutions have been selling calls and/or buying puts on the S&P 500. While it has not yet reached extreme levels on a daily basis, and volume has been low, the implications are more bearish than neutral for early next week.

Bottom Line: The various ratios here have not yet reached levels that could be considered bearish. However, we are very quickly approaching that situation, and the interaction between the various categories of traders is not encouraging. Equity traders have been focusing on calls while their more savvy brethren have been put-centric. This type of activity normally precedes lower prices and should be an alert that higher prices may not be sustainable.

Comment: The story here remains the same as it has been for two weeks now. We continue to see a lack of relative or absolute extremes in the VIX or VXN, and the volume and volatility we normally see near market lows is absent. I've been stressing that we need to see more intraday volatility with wider trading ranges and more volume in order to shake out the less-confident holders of stock and replace them with longer-term traders who will hold and buy more. This is most definitely not happening, as the average range in the S&P 500 over the past three days is 12.5 points. As a percentage of price, it is 1.5% (= 12.5 / 840) and that is a figure that has only preceded lower prices during this bear market. Likewise, the volume differential (see site for details) remains extremely low at -11%, and that is also a figure that has only preceded lower prices during the bear. This low volatility, while perhaps explained by the most uncertain geopolitical situation we have faced in decades, is not endemic of major market lows.

Bottom Line: The lack of recent volatility is troubling, and suggests the most likely course of action is further price declines. We need to see more volume and wider trading ranges in order to replace weak stock holders with "good" ones.

Comment: After reaching its most overbought condition in over a month, our shortest-term model backed off a bit with Friday's decline from the opening highs. Normally the market takes more time (or lower prices) to fully work off these types of overbought readings, so that would suggest we have further to go and any short-term rallies should be sold. There is always the danger that we could be embarking on a new longer-term trend, but until proven otherwise the better odds are with selling overbought conditions.

Bottom Line: The market normally takes time to work off such overbought conditions as we just saw in this model. This suggests that any rallies we see short-term should be sold.

Comment: With the breadth and put/call measurements having worked off their oversold conditions, and volatility remaining subdued, this model has dropped considerably in the past two weeks. The model never really reached extreme territory, instead just reaching a level that indicated pessimism was high enough to prompt scared traders into selling, but not high enough to get more opportunistic traders to buy. With that condition now gone, we're kind of stuck in no-man's land. Our shorter-term indicators like volatility and breadth are neutral (maybe even overbought) while longer-term measurements like the sentiment surveys are relatively oversold. This doesn't present us with much of an edge either way.

Bottom Line: Until we get more of an extreme either way here, I would avoid reading too much into this model's movements.

Comment: This model reflected an extreme in pessimism by February 10th, and the meandering market since then has caused the model to settle down and become neutral. While still somewhat high on an absolute basis, on a relative basis the model is close to touching its lower trading band. This usually happens fairly quickly after a pessimistic extreme is reached, and the closest comparison is probably the late December / early January period. While the model reached much lower levels in January than where it is currently, the concept is the same, as it reflects the first real rally from an oversold condition. How the market reacts to that rally is telling - is it the beginning of a new trend, or simply a bounce from oversold conditions in a downtrend? Until proven otherwise, I believe we must assume it is an oversold bounce, and look at higher prices as a selling opportunity.

Bottom Line: The model is currently neutral, but another rally attempt should push it firmly into overbought territory. Until the market proves otherwise, we should use overbought conditions as selling or shorting opportunities, and not chase prices higher.

I've been stressing recently that the highest-odds opportunities are with keeping trades very short-term and with tight reigns. Those who have been aggressive the past couple of weeks and held for more than a day or two likely have losses to show for their efforts. While I don't believe these conditions will last much longer, for now I think it remains the best way to navigate this market. Some of the bullish underpinnings to the market that existed a couple of weeks ago have dissipated, such as negative Rydex fund flows, high put/call readings, oversold breadth and oversold models. They have moved from oversold to neutral, but they are not yet overbought. This leaves us mired in something of a gray zone with no clear direction. Our longer-term measures are mostly positive, such as the sentiment surveys and public shorting indicators, even though some of them (like the II survey) have not reached the types of extremes they usually do at intermediate-term lows. Other than a few very short-term intraday movements, we have not seen any signs of a selling climax that would indicate an imminent rebound. I fear we are going to remain chained to every news item that comes out of Iraq or North Korea, and that will trump any technical or sentiment observation we make. For example, this weekend the U.S. captured someone they believe to be a major player within al Qaeda. Will the market take this as a positive that we are making progress in the war on terrorism, or a negative because it may trigger sympathetic radicals to carry out further attacks? Frankly, I have no idea and will not bore you with my thoughts, as I have no edge here. If we had some sort of pessimistic confluence sentiment-wise, then there would be an argument that most news headlines would be interpreted in a bullish manner. Until we get such a confluence, however, I don't see a way to game these developments. Therefore, I will continue to stress that trades should be kept short and small, with risk control the #1 priority. While I believe it is OK to trade either side of the market at this point, my preference remains to sell rallies barring some major geopolitical development.

This disclosure is not intended as trading advice in any form. It is meant as a note to subscribers that the author may have a position directly affected by the market outlook reflected in the commentary. Although the author takes great pains to remain objective in any commentaries, it is only fair that readers should know that the author may have taken positions in accordance with his market outlook. Positions can and do change at any time, without notice to the reader.