Getting Closer in Time and Price

Bottom Line: Survey participants in one of the less-followed sentiment surveys have become overwhelmingly bearish. While not a good sign for bulls in the short-term, it could have longer-term positive implications.

One of the characteristics of the market since August has been that traders have not believed in the rally nearly as much as they had the previous ones this year. We haven’t seen the type of option activity, odd lot behavior or Rydex frenzy that we did previously, and when price has contracted a bit, we have been seeing traders quickly jumping to the bearish side of the boat.

Another sign of that comes from the latest results from the lowrisk.com sentiment survey. This is not one of the “major” surveys that many people follow, but it has just as good a track record. The latest results, which include responses through Sunday evening, showed that only 11% of all respondents considered themselves to be bullish, meaning that they expected the Dow to be at least 2% lower 30 days hence.

This 11% reading is extraordinary – not just because prices haven’t fallen that much, but because this is the 3^rd-lowest reading in the survey’s history, dating back to 1997. The two dates when there were fewer bulls were 9/17/99 and 8/31/01, neither one being an immediately effective contrary signal – the Dow was an average of more than 4% lower the week after both readings. However, they also signaled that a good low was relatively close at hand.

The charts below show the two instances when we saw fewer bulls than now. The ratio represented on the chart is the bull ratio, which is simply the number of bulls expressed as a percentage of the total number of bulls and bears. In the latest survey, there were 11% bulls and 58% bears, so the bull ratio is 16% (= 11% / (11% + 58%)). This bull ratio is also the 3^rd-lowest in the survey’s history, with the same two dates in 1999 and 2001 exceeding the current one.

If you had bought based on this reading during 2001, obviously you would have taken quite a hit after the 9/11 atrocity. Still, even after the worst attack on U.S. soil in our history, if you had held on you would have been ahead after 12 weeks.

This degree of pessimism is obviously very rare, and so far has not been confirmed by any of the other surveys. It would be better to see more of a confluence of negativity across some of the other surveys which poll different sectors of the investment population. Still, when looking at the 10 instances in the survey when the percentage of bullish respondents has been the lowest, the S&P was higher after 12 weeks every time but once, sporting an average gain of 6.6% - and that one loss was a miniscule 0.4%.

Bottom Line: Traders have been keying off oil to help determine their posture, and if the pattern continues it could benefit stock prices.

Every once in a while, something garners so much attention that traders begin to key off that one lone idea in order to shape their trading decisions. Bonds are usually center stage, but every once in a while something else comes along. Whether it is a foreign market, a commodity, election results or whatever, this intense focus on a single product tends to become something of a self-fulfilling prophesy. Lately that focus has been on oil, which obviously is no great insight, but if the pattern holds up, it seems as though we may be seeing at least a pause in the march high in oil, and that has been a good thing for stocks.

The table below outlines each of the significant moves in oil over the past year, both rallies and declines. Shown are the number of days each took to play out, along with the percentage change in oil and the coincident change in the S&P 500 during those same dates.

Date of Top/Bottom	# Days in Move	% Change in Oil	% Return in S&P 500
TOPS IN OIL
10/15/2003	11	-4.3%	0.0%
11/18/2003	4	-6.8%	1.7%
01/22/2004	9	-5.5%	-1.5%
03/23/2004	7	-6.1%	3.5%
06/01/2004	19	-11.8%	1.3%
08/19/2004	7	-10.3%	0.7%
AVERAGE	10	-7.5%	1.0%

BOTTOMS IN OIL
09/17/2003	20	7.3%	2.0%
10/30/2003	13	8.7%	-1.2%
11/24/2003	36	16.6%	8.7%
02/04/2004	33	16.5%	-2.9%
04/01/2004	41	26.7%	-1.0%
06/29/2004	36	32.0%	-4.0%
AVERAGE	30	18.0%	0.3%

From the table, we can see that the average decline in crude oil futures took 10 days to play out, and the average decline was 7.5%. During this extremely strong uptrend, each of the rally phases took triple the amount of time, 30 days, to exhaust themselves and the average percentage increase was 18.0%. The most recent uptrend which began in late August ran 32 days (assuming October 14^th was a top) and December crude futures have rallied 29%. So, the recent rally has exceeded the average time by a couple of days and has been the second-largest in terms of percentage gain. According to the table, it would make sense if we see something of a short-term top in here which would be in keeping with the pattern oil has formed during this time.

Now if we look at how the S&P has performed during each of the phases, another clear pattern emerges. During the six declines where oil lost an average of 7.5%, the S&P showed a loss only once, and even then it was relatively minor. During the six rally phases in oil, however, the S&P showed a loss four times. There was one glaring exception, and that was the end of last year when both oil and the broader stock market rallied in unison.

If we make two relatively large assumptions, those being that oil peaked on October 14^th and that the pattern formed over the past year will continue, then we should expect oil to decline for about an additional one to two weeks, and lose another 5% or so. If that does occur, then it should serve to bolster stock prices.

Last time, I touched on the fact that the headline put/call ratio from the CBOE had shown more put volume than call volume for four out of five days. That rare occurrence does not often signal the exact low, but rather a point that is relatively close. What often occurs is that the broader market will chop around for a few days, then make one last dive lower before forming the final low. We saw something similar to that happen in March and May of this year, the only other times the put/call ratio put in such a performance. The market’s behavior so far is mirroring that activity closely, and if it continues we could expect some more chop, but we should at least see one more attempt to drive prices lower. If we do see such a thing in the next couple of days, I believe it would be a good time to initiate or add to longer-term long positions, as the risk/reward appears to be tilting more heavily in favor of longs for those with a time frame of at least several weeks.

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.