Worrying About The Wall Of Worry

Posted At 9:00 AM EST

Good morning...We begin the day with flat action in the pre-market futures as the morning's economic reports came in mostly in line.  The futures goosed up a little on the headline increase in consumer spending, until many realized that it was likely due to temporary government stimulus checks and we backed off quickly thereafter.

A piece of sentiment data that has permeated through trading desks since yesterday is the latest release of the sentiment poll from the American Association of Individual Investors (AAII).  Their weekly data shows that individuals have dropped to the lowest level of bullish opinion since March.

The responses to the data that I have seen have automatically - and without exception - assumed that this is bullish for the market going forward.  After all, the AAII data is a contrary indicator, so decreasing bullishness has to be a good sign for stocks, right?

Well, maybe...

I'm a pretty easy-going guy, but I do have my pet peeves.  One of them is this silly notion that "stocks climb a wall of worry".  They most certainly do not.  Stocks only rise when more people become more bullish, not bearish.  If people are becoming worried about stocks, then why the heck would they be buying them?

Sentiment works as a contrary indicator at extremes - not necessarily as a contrary indicator during the mushy middle parts.  In fact, during trends it works better as a confirming trend indicator than anything else.

So what about this AAII data?  Yes, it dropped to its lowest level of bullishness since March, but it's only in about the bottom quarter of all readings since the bear market began.  That's low, but not really an extreme, and it's not outside of the trading bands that we post on the site.

Let's try to find any time since the survey's inception in the late 1980's when the percentage of bulls dropped to a three-month low, but the S&P 500 had rallied at least 12% over those three months.

Uhh, we can't.  It's never happened.

How about after a 10% rally?  Then we get only two precedents (using Friday-to-Friday closing prices).  Those priors occurred on 04/26/91 and 03/07/97.  Over the following month, the S&P lost -0.4% and -5.9%, respectively.

To get more instances, let's drop the requirement to a three-month rally of 5% or more in the S&P.  In that case, 26 weeks qualify for the study.  And one month later, the S&P was positive 54% of the time with an average return of +0.5%, and an average drawdown (maximum loss) that almost exactly equaled the average maximum gain, around 2.1%.  That's not horrible, but it's certainly not the major buy signal that "wall of worry" proponents would probably suggest.

Over the past decade, we've seen this happen 11 times.  During the next month, the S&P managed to rally only 3 times, and its average return was -1.5%.  Lest you think this was purely confined to the bear markets, the last occurrence was on 08/05/05, fully in the midst of the last great bull run.  Over the next three months, the S&P lost close to -4%.

The time before that was 12/31/04, right before the S&P took another multi-month tumble.  The time before that was 01/30/04, after which the S&P topped out a few weeks later and tripped into May.

During the last bear market, we saw this occur on 06/08/01 and 01/11/02.  The S&P lost more than -4% over the next month both times.

I don't want to suggest that this is a sell signal.  We don't really have enough data, and enough of a risk/reward skew, to suggest that.  But I most definitely intend to suggest that this is not an automatic buy signal, either.  In order for prices to rise, we need folks to become more bullish, not less...unless they've become so pessimistic that we can consider it extreme enough to be a contrary indicator.  We don't have that with the AAII data.

Bottom line - Intermediate-term Outlook: Neutral (since April 9, SPX 843)

Beginning in early March, we discussed a large number of reasons to expect an 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.

During mid-April, several of our measures like the Indicator Score and Dumb Money Confidence reached levels that usually result in either a flattening out of the price rally, or an outright decline, especially during a bear market.

But the market held up extremely well in spite of some of these overbought types of indications.  This is very rare during an ongoing bear market, and is important to keep in mind especially given many of the "this time is different" kinds of studies we reiterated in early May.

While there have been - and continue to be - many reasons to consider this rally something different than we'd seen previously in the bear market, I've been looking for the S&P to run into trouble if it traded into 940-950, which it happened earlier this month.  I wasn't expecting any kind of waterfall decline to new lows, just more of a pullback than we'd seen.

What's made this juncture so difficult is that despite so many signs of "this time is different" and the market doing nothing wrong, there are some troubling signs out there.  We touched on a couple very recently, like the surge in speculative trading and the return of bullish opinion.  Because of that, I've been leery of the S&P's chances to hold a breakout above 950.

With the most recent surge in the spread between the Dumb Money and Smart Money Confidence, and the tendency for initial breakouts from volatility coils to be "false", I was looking for the first breakout above 950 to be beaten back.  Now that that's happened and we're nearing the opposite end of the May - June range, we need to see how the market responds to short-term oversold conditions, especially now that we've seen a "failed" rally above the 200-day average.

The recent 90% down volume readings when coming off of an intermediate-term high aren't necessarily a sign that the trend is changing, but if we can't get meaningful bounces from oversold conditions, and especially if we lose the 880ish area on the S&P, then a re-test of the March low looks to be in order.  So far the market has passed these tests.

Bottom line - Short-term Outlook:  25% Bearish  (Since June 25, SPX 918)

Yesterday morning I mentioned that normally when the S&P is positive on the day of an FOMC meeting, it shows significant weakness in the day(s) following.  I would usually look to short a close like Wednesday's, but I was put off by the historic weakness we saw after the announcement, and unsure if that weakened the sell signal.

Apparently it did, as stocks roared back yesterday.  The bounce back was been enough to push our shortest-term guides into overbought territory, with the intraday version of the STEM.MR Model stretching all the way to 18%, the most extreme since March.  With the exception of the failed overbought signals coming right out of the March low, the S&P has struggled to maintain its short-term upside momentum the 7 other times we've hit or approached overbought in that model.

We also have a few signposts that triggered, such as the tendency to under-perform after three straight up days during a bear market.  We've also seen consistent weakness when the S&P rallies at least +1.5% but the Arms Index (also known as the TRIN) is over 1.0.  That means that there is relatively less volume flowing into up issues than down issues, a sign of less than enthusiastic buying pressure.

My final figures show that the S&P closed up by more than +2%, but the TRIN closed at 1.15 (different vendors will have different values for the TRIN - I'm using what I've always used).  There have been 11 other times this has happened since January 1975, and two days later the S&P was negative every time by an average of -2.9%.  Very odd.

I'm leery of the concept of window dressing into the end of the quarter, so as the S&P fills its downside gap from Monday morning and flirts with last week's highs in that 925ish zone, I'd be surprised to see a sustained breakout above there in the coming day(s).

All the best,