Decline Should Set Stage for Longs
Tuesday, August 3rd, 2004 8:15pm EST
Lowrisk Now Suggesting Risk is Low
Bottom Line: In something of a break from other sentiment surveys, the lowrisk.com poll is showing an extremely low level of bullish opinion, and that has a good track record of being positive for the market.
When most think of investor sentiment, the standard is the Investor’s Intelligence sentiment survey. While that is the granddaddy of the sentiment surveys, there are many others, and most are just as useful. They tend to track each other very closely, but there are times, like now, where they can diverge greatly.
I touched on the lowrisk.com survey in an intraday note last week, with its extremely low level of bullish respondents being one reason to be a bit more constructive on the market last week. Once again this week (including responses through Sunday), the survey came in with a low amount of bullish opinion. This has moved the 4-week moving average of the bull ratio down to an extremely low 29%.
The chart below highlights each time in the survey’s history that the 4-week average reached such a low level. Occurrences are marked by a green arrow.
Four weeks after the ratio hit such a low level, the Dow was higher 13 out of 17 times, with an average return of 3.4%. While I’m not a fan of excluding data, if we take out the instance that occurred right before 9/11, the average return climbs to 4.4%. Interestingly, 12 weeks after we saw such a low opinion of the market’s prospects, the Dow was higher 17 out of 17 times, and the average return was a robust 8.2% (leading to an average annualized return of around 34%).
Let’s make a very quick, rudimentary trading system out of this. We’ll buy the Dow any time the 4-week average of the bull ratio drops below 30%, and we’ll sell our position 12 weeks later, or when the bull ratio snaps back above 50%, whichever comes first. Such a system would have had 8 trades since 1997, with 7 of them winners. The average gain would have been 6%, and the one loss was 0.3%. Assuming you had invested $10,000 in the system initially, it would have grown to just under $15,000 by now, beating a buy-and-hold return handily despite being in the market for only 81 out of 378 weeks (about 21% of the time). And your drawdown would have been much better too. I wouldn’t recommend anyone do this going forward, but it’s a telling exercise to see how useful the data would have been.
The lowrisk survey, along with Consensus and to some degree AAII, are showing a low level of bullish opinion among their broad base of respondents. That is not being confirmed to any degree by Investor’s Intelligence or Market Vane, two populations that have remained remarkably bullish for over a year. The lowrisk and AAII surveys are typically made up of small, “retail” traders, which helps to possibly explain why odd lot traders are showing so much bearishness (though our R.O.B.O. put/call ratioTM of small-trader opening option purchases is still not showing those options traders scrambling for put protection). The Investor’s Intelligence and Market Vane surveys are made up of newsletter writers and Commodity Trading Advisors, respectively, and these “professionals” have not budged for any length of time since last June. It would be best if we could see wholesale pessimism among the entire sweep of surveys, but what we have now is a good start. Excessive pessimism being exhibited from the two surveys which most closely track amateur investors is a positive sign that we could see at least a tradable low soon.
Sector Update
Bottom Line: We look at updated asset levels from two sectors which Rydex traders had opposite opinions on a month and a half ago. They have somewhat predictably undergone opposite fates, further increasing the confidence of using Rydex traders as a contrary indicator.
One of my consistent assertions is that those who trade the Rydex funds are a good “fade”, meaning that it almost always pays to take the other side of whatever trade they seem to be piling into when they form a consensus. Another glaring example of this is apparent when we check into a sector play that I highlighted on June 13th.
At the time, I noted that Rydex traders were investing aggressively in the Consumer Products sector. While that sector had not yet broken above its May highs, assets in the Rydex fund had ballooned to significantly higher than they were in May. That told us that these traders were confident of an upside breakout and more sustained rally. On the other hand, the Leisure and Basic Materials sectors were not getting any “love” whatsoever, despite healthy rallies of their own. Let’s see how the sectors have done since then:
I pointed out two exchange-traded funds (ETFs) in the June comment which tracked those sectors, XLB for Basic Materials and XLY for Consumer Products. Since June 13th, XLB has rallied as much as 4% and was about 2.5% higher as of yesterday. XLY, on the other hand, never really rallied much beyond that point and declined nearly 7% at its low. It was about 4.5% lower as of yesterday.
While I don’t recommend spread trades per se, I do think this type of analysis is an excellent starting point for further technical and fundamental research. By observing how the wrong-way Rydex traders were treating two particular sectors, we were clued in to a market-neutral approach that would have worked phenomenally well, for the second time so far this year. Currently, the assets are back to about where one would expect them to be (though they still seem a bit low in Basic Materials), so my preference would be to move on. I don’t see much currently among the sector funds that is especially intriguing, but I do suggest you watch the asset levels closely for future sector tip-offs.
Conclusion
In the last couple of Short-Term Summaries on the Daily Overview page, we’ve noted the lack of an edge from our shortest-term measures. That still hasn’t changed much, even with today’s relatively stiff decline in technology shares. Our NDX-focused indicators are just entering oversold territory, and haven’t quite reached extremes just yet. A large-ish gap down open (say 10 points or so on the NDX) would still likely lead to a very short-term snapback, but it’s not as high-odds as I would like.
I stated last time that we’re at a more difficult juncture now than at any point this year. The broader market has done very well this year in adhering to overbought and oversold sentiment conditions, but it’s difficult to judge just where we are in the cycle at this point, unlike the lows in March and May and the highs in April and June. We’re certainly seeing a few signs of give-up among small or unsophisticated traders, but we’re nowhere near the confluence we saw a couple of other times this year. At this point, I’m going to stick with my thoughts from last time…downside risk is probably limited, at least for the next few weeks, and I will be approaching any further declines as opportunities to possibly add to long positions. However, should the S&P break and hold below 1075, we could see a spike in selling as obvious support is broken. That should set up a better longer-term situation for longs, but we’ll cross that bridge if we come to it.
Jason Goepfert
President and CEO
Sundial Capital Research, Inc.
Disclosure: no positions
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.
© 2004 Sundial Capital Research, Inc. All Rights Reserved.