Starting to Get That Panicky Feeling Again

In several of the daily notes lately, I've been showing a chart of a handful of indicators I watch on a regular basis to try to get a handle on our short-term sentiment and breadth condition.

It's certainly not an exhaustive list of indicators or necessarily the "best" ones, but they have a good track record, and they give us a decent cross-sectional view among the many choices on the site.

I get asked all the time which ones an investor (not a trader) should look at. It's easy to get fixated on the short-term view and lose sight of the bigger picture, so let's go through the same exercise and show a chart with a handpicked list of indicators that I think represent our indicators well, and have done a good job in the past - but from an intermediate- to long-term point of view.

Because there were quite a few that I wanted to share, I've broken it down into two charts with seven total indicators.

The Smart Money / Dumb Money Confidence Spread subtracts the "dumb money" from the "smart money" to give us one quick view of where we stand in the sentiment cycle. The further the line is below the green dotted line, the better it has been for the market.

The spread has now moved to +29%, the most extreme reading since the spring panic. That is due to a sudden and substantial drop in the Dumb Money Confidence in a market rally, which has moved from over 70% in mid-May to under 30% now.

When the figure has gotten this low in the past, it has been a remarkable intermediate-term positive for equities, regardless of where the Smart Money was at the time.

S&P 500 Performance When Dumb Money Confidence Equals 29% Or Less 1995-2008
	5 Days	10 Days	1 Month	3 Months
	Later	Later	Later	Later
Avg Return	+1.2%	+2.0%	+4.7%	+12.3%
% Positive	70%	74%	86%	100%
Avg Max Gain	+3.0%	+4.4%	+7.0%	+14.8%
Avg Max Loss	-2.3%	-3.1%	-3.8%	-4.2%

Three months later, the S&P 500 was positive after all 163 days that showed a Dumb Money reading of 29% or below. Even though the study is only from 1995 forward, it includes 74 days - nearly half the sample - from the current and former bear market.

The average three-month performance translates into an annual return of nearly 50%, but just as impressive is that the average reward is more than three times greater than the average risk. With that kind of skew, such a high average return, and the great consistency of positive future performance, this is a substantial positive.

The Percentage of S&P 500 Stocks Trading Above Their 50-day Moving Average shows just what it sounds like - what percentage of the components in the S&P 500 index closed the last trading session above their respective simple 50-day moving averages. The more the stocks under their 50-day average, the more oversold the market and the more likely it is to snap back.

In mid-May, the percentage kissed the overbought level of 80%, and that about marked the high for the market. In strong markets, we see the indices continue higher after hitting overbought readings (like during the third quarter of 2006), while in weak ones we see the indices cower immediately after hitting overbought. That's what happened this time, and we haven't yet cycled back down to oversold. This one is neutral to negative for the market at the moment.

The InsiderScore.com^TM Buy/Sell Ratio is a proprietary look at corporate insider buying and selling activity from the good folks at InsiderScore.com. The lower the line on the chart, the more we're seeing insiders buy their own stock - and the better the sign for the market.

The indicator has been stuck in varying degrees of "oversold" for the past year, meaning that we've seen corporate insiders more or less net buyers of their stock during most of the downtrend. That might not seem so smart, but these folks generally have a multi-year time frame and when we've seen big spikes in the ratio, the market has typically followed.

The latest data shows the indicator still in bullish territory for stocks, but not nearly to the degree we saw during the spring panic.

Hedge Fund Equity Exposure is a unique measurement of how Commodity Trading Advisors (CTAs) are positioned towards equities, based on a proprietary look at fund returns via Carpenter Analytix. Despite these guys being professional traders, they still fall into the problem of group-think and extremes in their exposure to equities works well as a contrary indicator. So the lower the line, the less exposed funds are to equities - and the more potential buying power there is on the sidelines.

This indicator has shown hedge funds to be pushing their short-side bets since the spring, which in true contrary fashion has been a pretty good positive for the market. We're starting to see it creep higher lately, however, even as stocks are dropping, suggesting that these guys are covering shorts and buying into falling prices. These are trend-followers at heart, and this is a-typical behavior.

During the bull run from 2003 - 2007, buying the market when hedge funds went net short was a fantastic strategy. During the last bear market, not so much. We saw these guys become exceptionally net short in the fall of 2001, so the current extreme could certainly become more so. This is still what I would consider a positive for stocks at this point, but it's a tenuous one.

The Equity-only Put/Call Ratio (De-trended) shows us how much demand there is for downside protection. It is calculated by taking the Equity-only Put/Call Ratio and correcting for its long-term trends. The closer the blue line is to the green dotted line, the more demand there is for puts, and the more positive it is for the market.

Demand for puts has been rising lately (showing an increasing amount of concern), but has not yet reached a point that has been seen at almost every other intermediate-term market low. It has been exceptionally rare to find a multi-month market low over the past decade that has not been accompanied by an extreme in put/call ratios...in fact, I can't really find even one.

And even more troubling, the smallest of options traders - who should be the most wrong, most consistently - have not altered their behavior much at all, even after last week's drubbing.

The latest data shows that the very smallest of traders, trading 10 contracts or less at a time, spent 38% of their volume buying speculative call options last week, the same amount as the previous week. They spent only 22% on protective put options, down 1% from the prior week. So even after the indices slid several percent, these wrong-way traders felt no need to increase their protection. That ain't good.

The Stock/Bond Ratio essentially compares how cheap stocks are to bonds. It is nothing like the traditional "Fed Model", rather it looks at how extreme the recent move in stocks has been relative to bonds, as sharp moves one way or the other tend to get reversed. The lower the line is on the chart, the more under-valued stocks are.

We're just coming off an "overvalued" extreme here, and the ratio has just made it back to the zero line. I can't find any information hidden in the current reading and I consider it perfectly neutral.

The Rydex Leveraged Long/Short Ratio looks at how much money traders in the Rydex family of mutual funds are putting into leveraged long funds versus leveraged inverse funds. The lower the ratio, the more bearish the traders - and the more positive for the market.

In mid-May, we saw traders buying into the leveraged long funds at a pace that was one and a half times greater than what was flowing into the inverse (i.e. short) funds. As we discussed in May, for the Nasdaq 100 funds the ratio was over 2.0. That was enough to consider it extreme, and a warning sign of too much optimism.

That trend has reversed along with the last few weeks of selling pressure, and we're back to neutral here. It will take another week or two of declining prices, at least, before we see the ratio tip back towards the other extreme and give us a suggestion of too much pessimism.

Conclusion: Some hints of too much pessimism, but probably not enough just yet

The most intriguing thing to me right now is the stat regarding market performance following Dumb Money readings of 29% or under. With a perfect record of higher prices three months later, the data is skewed enough for me to consider it a very solid edge.

A concern is that the data only reliably goes back to 1995, but to be fair that includes a vicious multi-year bear market and another six months of one since last October, so it's not like the data is completely un-tested in real-time trading. A lot has been thrown at it, and it has held up well so far. It will no doubt fail at some point, and if we're on the cusp of a summer of 2002 kind of scenario, now would be the time.

Looking just at that data and nothing else, it would make a whole world of sense to become fully invested (or more) on a short-, intermediate- and perhaps even long-term time frame. But I don't like to focus on just one piece of information, rather I like to weight all the evidence.

And when I do that, the argument for a sustained rally becomes less exciting. We are seeing continued buying by corporate insiders, which is good. Also good is the fact that hedge funds are not positioned well for a rally, and there is absolutely massive amounts of cash on the sidelines in money markets and brokerage accounts.

But we're not really "oversold" on a level that compares to past lows when looking at market breadth, or options market data or Rydex trader behavior, among a few others. We never get 100% of our indicators lined up in one direction (though it was close in March), but I would like to see more evidence of fear or at least deep concern among more of our indicators to be confident that this bear market is due for another multi-week (or better) rebound.

There are certainly signs of capitulation in the banking sector, which is a positive. We also have seen relative strength in technology in small caps, which is also good, as the broad market tends to do well going forward when those sectors are leading. So if we can get some better trading in the banks, and tech continues its leadership role, then the recent move in the Dumb Money may just be enough to give us another shot at a more intermediate-term rally.

Those are some big "ifs", and by the time we get the confirmation we need the rally would have already been well underway, but the penalty for buying too aggressively too early could be stiff indeed if this bear market continues to progress to a point where we register the same kind of panic extremes that we did in January and March. As it stands right now, I'm not ready to be an aggressive buyer, and probably won't be unless we see quite a few more signs of panic, or begin to stabilize and see the S&P hold above 1370ish.

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