The Bulls Break Out

04/16/09 8:45 AM EST

Good Thursday morning...We begin the day with some strength in the pre-market futures as we once again saw a rally once European markets opened for trading.  It has been a very volatile overnight session, and traders are getting antsy as we attempt to kiss the recent highs.

Among the most antsy are recent converts to the bull camp, and from the looks of things there are quite a few there.  Yesterday's release of the Investor's Intelligence survey of newsletter writers showed that that group had once again ratcheted up their bullish inclinations, pushing the Bull Ratio (Bulls / (Bulls + Bears)) to one of the highest levels of the past year.

Usually, sentiment goes along with the market, so a pickup in bullishness over the past few weeks is not at all unexpected.  But the magnitude of the change may be notable.

That Bull Ratio on the I.I. survey has now broken out above its downtrend formed from the peak in 2007, which is curious for two reasons:  1) The S&P 500 remains well within its own downtrend, showing no signs of justifying the breakout in optimism, and 2) Breakouts in the Bull Ratio have in the past signaled changes in market environment.

Let's go back over the past 30 years and try to find any other instances when the Bull Ratio broke out of a clear downtrend.  First up, the last bear market:

The 2003 instance isn't very similar to our current juncture, since the Bull Ratio had formed a five-year downtrend, while the current one is only a year-and-a-half old.

Also, while it's hard to make out on the chart, the breakout in the Bull Ratio coincided with a breakout in the S&P 500 in May 2003, when the index exceeded the prior swing highs in November 2002 and January 2003, and also above the downtrend line from the September 2000 through March 2002 peaks.  This makes it easier to suggest that the breakout in the Bull Ratio in 2003 was more justified than the current one.

On to the next candidate, from 1995:

You might argue with my version of the downtrend line, and I wouldn't protest too much.  I'm pretty strict with how I draw trendlines, preferring no violations of the line between two extreme points.

There was a temporary spike in optimism in 1992 that clearly breaks the downtrend line.  A "pure" trendline would include that point, but I'm ignoring it as an outlier for these purposes in order to show the clear trend in the Bull Ratio from 1991 through 1994.

By the time the Bull Ratio emerged from its downtrend, stocks had already done so by pushing strongly off the 1994 low and, in fact, trading at multi-year highs.  A breakout in optimism seems clearly justified in that case.

Let's rewind a few more years to 1991:

This is a much cleaner break of the downtrend in the Bull Ratio, even though it didn't last very long.  A few weeks after the breakout, it went right back into its range and started forming the downtrend from the previous chart.

But we didn't know that was going to happen at the time of the breakout, so on the "hard right edge", it was a valid break.  Again, the breakout in optimism occurred as the S&P was pushing strongly off of a low in 1990.

At the time, the S&P was above but not clearly breaking away from the previous high in July 1990, so suggesting the renewed optimism was justified or not is questionable, but much more of a clear case than our current situation.

Now the most ancient occurrence, from 1982:

This turned out to be a somewhat messy breakout as well.  The Bull Ratio violated its downtrend line in early September 1982, but then went right back into the range, chopping around until a stronger breakout in early 1983.

But at the time, in September 1982, the breakout in the Bull Ratio coincided almost perfectly with the breakout in the S&P 500, as it emerged from the downtrend defined by the peak in 1980 and throughout 1981.  So once again, the breakout in bullishness appeared justifiable given the performance in the S&P.

Whenever we discuss trendlines, we get into a very subjective area, and I don't like that.  We can't test it very well going back through history, and like we saw in the early 1990's, the most objective trendline may not be the best one to use (that's open to interpretation of course).

The point in looking at it this way is to see the changing regimes in sentiment - are we just seeing a continuation of the cycle, or are investors starting to behave differently?  As we saw in the charts above, in the past when investors broke out of long-term slumps in optimism, stocks did quite well indeed over the next few years.

That brings the current breakout into focus, and there are a couple of issues:

1.  The current breakout in optimism doesn't seem justified given the price action.  Yes, we're up 20%+ over the past month, but we haven't even eclipsed the prior swing high (either from February or January of this year depending on how strict you want to be), much less broken the long-term downtrend from the October 2007 peak.  Each of the other breakouts in bullishness we looked at seemed more justified given the price action.

2.  Whether we've actually "broken out" right now is up for argument.  We have seemingly broken the trend in pessimism, but the trend has been very short and extremely steep when compared to all the others.  We could, in fact, zoom out and suggest that from the ultimate peak in optimism in June 2003, the Bull Ratio is still trading in a six-year downtrend that wouldn't be broken unless it gets up to 75% or so.

Bottom line, I think it would be a stretch to suggest that the current break in the downtrend of the Bull Ratio is a good thing.  It does perhaps show a change in character from what we've seen so far during the bear market (and any change in that sense is a good thing), but the two concerns above make me leery of suggesting we're seeing a repeat of 2003 or the others.

This breakout in optimism is the kind of thing that has propelled our Intermediate-term Indicator Score to 69%, its 2nd-most extreme reading since the bear market began.  Only a few days in mid-May 2008 can lay claim to more excessive levels.  Mid-May, if you recall, was not a good time to expect a sustained advance.

This is also evident in the Confidence Indexes.

Smart Money Confidence is now at its lowest levels of the bear market, while Dumb Money Confidence is near its prior peaks.  That leaves the spread between the two at the most-extreme mark other than those few days last May.

These kinds of extremes have been very good at highlighting times when further rallies have petered out very quickly, and usually resulted in quick declines.  We must always keep in mind, though, that they can fail and usually will during the powerful phase of a new bull market.  That's what happened in the fall of 2003.

Given some of the studies we discussed last month, it's possible we're seeing something similar now, the emergence of a new bull.  But it's awfully early to be seeing these kinds of readings given the S&P's relation to its prior highs - usually when sentiment has become this optimistic, it has been more justified by the price action.

On a side note:

I want to clarify something about the content on the site.  Some subscribers have become confused (and rightly so), not knowing what is posted where or when.

So to clarify:

Morning Market Comment - This is the "meat" of the comments.  It is posted to the site each morning before the open and emailed to subscribers only.

Intraday Market Update - This is posted to the site during the day if something major arises, otherwise near the close most days unless there's nothing to say, and emailed to those subscribers who elect to receive it.

Blog - The "Sentiment's Edge" blog is a new platform.  This is public, and I've gone back and forth about what to put there and how to have it delivered.  Going forward, it will be meant as more of an educational, informal discussion related to sentiment (mostly, but I reserve the right to digress) with no set publishing schedule.  If you choose not to read it, no big deal.  If you really want the posts emailed, we can hook it up to a Feedburner feed and you'll receive a digest of everything posted the previous day.  You can find the blog here.

Twitter - Twitter is the new cool kid on the internet.  These things often flame out, but I do see some good uses for the service.  Unfortunately, it has become a playground littered with effluvia such as what color underwear people are wearing, so I use it sparingly.  I'll post quick stats, links or other items that may be of sentiment-related interest with no set publishing schedule, but again it is not "must read" and if you choose to ignore it, no big deal.  You can find the Twitter posts here.

Bottom line - Intermediate-term

Beginning in early March, we discussed a large number of reasons to expect another imminent rally of one to three months' duration.  Some of those studies were even more positive, and suggested not just a rally, but possibly a new bull market.  The behavior we saw early last month was reminiscent, on a number of levels, to the ends of prior bear markets.

After the 20%+ rally, our current juncture is somewhat similar to where we were in January of this year.  At that point, we'd gone over a number of studies in late November and early December that suggested the possibility of a longer-term advance.  But our indicators had become stretched to "caution" territory, and the market fell apart almost immediately thereafter.

We're faced with something similar now.  On the one hand, we have a number of studies based on past behavior that suggest more upside to come.  On the other hand, we have things like the Indicator Score, Dumb Money Confidence and other potential roadblocks like we discussed last week (see here and here).

The market so far has held up well in spite of some shorter-term overbought conditions and other situations when it rolled over immediately before, so that's a point in favor of further upside.  But when looking at our current position objectively, it's hard to find a solid edge given the battle between the studies (which point higher) and the current status of the indicators (which are neutral to negative for the market).

It's entirely possible that we're in an "April 2003" kind of place and we'll just keep steaming higher as we emerge from the bear market.  Personally, I'm not comfortable betting on that, and prefer to back off and look for shorter-term opportunities in what I think will most likely be a multi-week or multi-month trading range between 850-875 on the upside and 730-760 on the downside.  Given what we discussed above, I'm inclined to believe that a push near or above the recent high at 860 will ultimately be a "false" upside breakout and would look for considerable weakness when the uptrend is broken.

Bottom line - Short-term

Yesterday I mentioned that my initial target for a pullback from 860ish was 825-830, which was nearly met in the pre-market yesterday and since then we've seen a whippy move back near the top end of the recent range.  Once again, the big gap down in Intel proved to be more of a contrary indicator for the day.

The futures were heading for a gap down this morning, but once again we witnessed a rally after the opening of the European markets and now we're facing a small gap up.

Our shortest-term guides haven't been able to generate any real extremes lately as the market has been very whippy and choppy over the past several days, not enough of a consistent move to push them outside their trading bands, so they're not much help at the moment.

Without many extremes in the short-term, it's hard to get a read on the next couple of sessions.  When Intel has gapped down in the past, then we saw a recovery that day in the S&P, we've usually seen weakness in the few days following.  We do have option expiration looming, which can make things quite choppy and I usually avoid taking short-term positions the day or two before expiry.

I do think we're getting very near a peak of some importance - not one that leads to new lows, but at least a multi-week to multi-month pullback - and would be looking at any rally into 860-875 today or Friday to just about mark the end of it.  Ideally we'd get some overbought readings among the short-term guides but I doubt that's going to happen.

All the best,