Don't Worry - Be Happy!

By Frank Barbera CMT. January 16, 2007

“Here is a little song I wrote, You might want to sing it note for note, Don't worry, Be happy,” sings the stock market, playing the role of pied piper as investors are once again feeling quite emboldened. Perhaps it is the fact that over the last thirty weeks, the market has closed higher using a weekly median change 21 of the last 26 weeks. How often has that happened you ask? Well, going back to 1950, as can be seen in the chart below, only about 12 times in the last 40 years has the stock market turned in such a robust, one sided, and ‘compact’ advance. In graphic form, we computed each week’s S&P 500 Median close (the average of the High and Low), and then from that, the Weekly Median Change. Using the median smoothes out some of the noise; we used 26 weeks because it represents half a year. We then asked the computer to show us the history of

these ultra concentrated rallies, wherein the market advanced in a highly one-directional manner. In some instances, these types of rallies were the starting point of even longer bull market advances such as 1994, 1985, 1963, or 1954. However, in all of those instances, elongated declines or consolidations had followed in the prior year. What’s more, we noticed a very different reaction on the market's behalf when differentiating between strong “secular bull market environments” like the 1950’s and 1980's versus the more “trading range” oriented climate of the 1970’s. In these latter periods, where the primary trend of the market was really “giant sideways” over the course of time, high readings on the “Weeks Up per 26 Gauge” were not good times to invest in stocks. Note on the close-up chart of the 1970’s shown below, virtually every time the indicator moved up to the high end of the range the market was set up for a correction or worse.

In looking back, it is clear that at times one sided directional moves that are sustained with a very high and persistent trend can generate the kind of excessive bullish sentiment often evident at important market peaks. In the 1970’s for example, high “excessive” bullish sentiment readings attended a number of the same peaks including the highs of April 1971 and January 1973.

In the chart above, I show the 5 Week Exponential Moving Average of the Percent Bulls Indicator from Investors Intelligence. I have also plotted on the chart the Kase 'Peak Out' Line, which is a three sigma deviation from the mean. This work was first published by Cynthia Kase, author of the book “Trading with the Odds.” In my work I have applied the concept of the Peak Out Line to a variety of different tools including momentum indicators like MACD and a variety of sentiment polls. Whenever the 5 week average for Investors Intelligence, the oldest of the Sentiment Polls, is above the Kase Peak Out Line, it means that the degree of bullish sentiment is ultra-extreme. This was clearly the case (no pun intended) at a number of the highs in the 1970’s. Now let's flash-forward to today’s market and look at the same gauge. Here again we find very high degrees of excessive bullish sentiment with the Investors Intelligence gauge well above its Kase Peak Out Line.

Does this mean that the market must turn down immediately? The answer to that question is unequivocally, “No.” Excess sentiment can often lead final price highs by more than a few weeks, so there is great need for caution in using this data. What it does tell us is that the odds of making money by putting new capital to work at these levels are probably — over time — not very good. Other sentiment gauges are also reflecting a very optimistic view, which from a contrarian point of view is definitely something to “worry” about. This need for caution when viewing the broad stock market at this time is being reflected by a number of other gauges. Among the various sentiment polls, the historically grounded MarketVane Survey is also showing very high levels of bullish enthusiasm. If everyone is so confident that the market is headed higher, most often it means that most of the money available to move into the stock market is already invested. This means there may not be as much capital left over to drive the market even higher. In reviewing the MarketVane data the last few weeks we have seen better than 70% Bulls. That is not a good sign. In my work, I de-trend the data to form an oscillator which is done by calculating a five week moving average and then subtract 50 from the result. Typically, the MarketVane Survey tends to oscillate approximately 20% above and below this mean. As can be seen, the current figures shown on the next chart are the highest, most optimistic set of numbers seen since the 1997 and 1998 time period nearly 10 years ago.

Above: the MarketVane Oscillator, using a 5 week moving average.

I would also add that not long after the 1997 figures were seen, the Russian Crisis hit; and in 1998, not long after the high figures were seen, the Asia Crisis hit. In both cases, putting capital to work against the backdrop of those types of high sentiment readings was a recipe for serious heartburn and more than a few Maalox moments.

In addition to the Sentiment Surveys I also track the flow of capital throughout the Rydex Family of funds. These indicators also make excellent tools because they reflect the real movement of capital, not just someone’s opinion, be they a floor trader, retail investor, or newsletter writer. The old saying is “talk’s cheap” and "action speaks louder than words." Well, tracking the Rydex data tells us a lot about what actions investors are really taking. In my work, I maintain a medium-term model that tracks the inflow of capital into Bear Funds versus Bull Funds, wherein “high” readings reflect deep levels of pessimism and fear (the ingredients for major lows) while conversely, low readings reflect high levels of optimism engendering market peaks.

Note that over the last 8 years we have seen big spikes up into the Fear Zone (high end of range) that attended important lows on June 20, 2006 +37.48, August 17, 2004 +41.21, February 12th, 2003 +64.85, October 9, 2002 +60.19, September 24, 2002 +61.34, and September 29, 1999 +49.37. In each case, the broad stock market was near a major bottom and proceeded to advance strongly for months on end. Shifting next to the low end of the range, trough readings reflecting high levels of market optimism were seen on:

July 16, 1999	—39.28%
August 28, 2000	—41.33%
January 30, 2001	—50.54%
May 22, 2001	—39.40%
January 21, 2004	—46.12%
December 31, 2004	—43.64%

Guess what? On January 8th — Monday of last week — my Rydex Medium Term Model fell to a reading of —49.56%. That’s right, -49.56%, which is the third lowest daily close ever seen. Only two days in the balance of the entire last decade generated lower daily closes, and those were January 30, 2001 -50.54, and June 14, 2000 —51.69, and a close up view of where the stock market was on the dates of those readings (below) does not suggest promising results.

In addition to the Rydex Data, for many years I have tracked a variety of options-related gauges to get a feel for market sentiment. Here again, one of the favorite Medium Term gauges, the Dollar Weighted Put-to-Call Premium Oscillator for the stock market, has once again declined to ultra low values below —40%. While these readings can also be “early” in forecasting market peaks, they reflect a high level of optimism by options buyers, and a lot of consensus thinking. Rarely does the stock market accommodate the crowd.

Above: the Dollar Weighted Put-to-Call Premium Oscillator broad stock market.

Finally, when looking around the market for value, there is one area that's starting to stand out and that is Natural Resources, and Energy in particular. On January 3rd of this year I went on record with my gold letter subscribers saying that I thought Crude Oil was breaking down. I stated, “Late in the day today, Crude Oil made fresh contract lows, and in my judgment, could spike down toward $51-$52 over the next few days. At that point, I suspect that Crude Oil could be near its lows for the year and in an area where a more major upside reversal could develop over the course of time.” At the time, Crude closed at $58.05. Since then, that downside objective has been met. While I still believe Crude may marginally overshoot $50 on the downside (for perhaps one day), overall Oil looks a lot closer to a low than anything else. At the moment, where the Oil Service stocks are concerned, we see broad scale fear — actually bordering on terror — being reflected in a gigantic spike up in the Put-Call Ratio.

While this is also very likely “a bit early,” I believe that ultimately, there is a good chance that the current high levels of “fear” being seen in the Energy space will usher in yet another important low for Oil and Oil related stocks. As a contrary investor, the aim is always to put money to work when fear levels are high, or put another way, to “buy the fear.” Within the broad stock market, only the Natural Resource sector is recording high levels of fear (ideal for “bottoms”) and as it happens, coupled with near record low valuations, could make for some very exciting returns if and when prices finally begin to firm.

At the close today, the DJIA gained 24.03 to 12580.59, with the S&P 500 up .94 at 1431.67 and the NASDAQ lower by 5.04 index points to end 2497.78. Crude Oil plunged 1.78 to end at $51.21 while nearby Gold fell $1.00 to finish at $625.90. The 10-Year Bond ended with a yield of 4.75%.

That’s all for now.

Frank Barbera

Contact Information

Frank Barbera CMT
Editor, Gold Stock Technician
PO Box 48072
Los Angeles, CA 90048
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