Happy Days Are Here Again
By Frank Barbera CMT. June 9, 2009
Since we began getting cautious on the US Stock Market back on May 12th with the S&P at 912, the index has retained a bullish bias, but has nevertheless largely remained in a range (+/- 30 S&P Index points around 912) with lows in the 880 area and highs in the 940 zone, abutting the January 2009 peak. In a recent GST newsletter I told readers that I expected one final push to the low 940 area which then developed the following day. Nevertheless, the stock market has gone from “disaster central” six months ago to apparently ‘bullet proof’ right now, refusing to decline. This leaves investors with a difficult dilemma, to either jump on board the stock market advance or hold off and hope that prices relent.
At the recent Morningstar Conference in Chicago, I had a chance to catch up with legendary investor Jeremy Grantham who did an excellent job in discerning the recent market low. His advice to investors interested in ‘jumping on board’ the advance was a “go-slow” message. He likened the rally as the return of crazed institutional investors engaged once again in the lemming like ‘investment performance derby.’ Hence, there is no solid ‘logic’ for this advance, just a lot of panicked money managers who will lose their jobs if they don’t put money to work. Can you believe how stupid this industry has become? All the research, all the analysis, and in the end, investment managers squander investor capital because they are too scared to take an independent stand. Well, ten years of that approach has produced, guess what? Negative returns -- big surprise! In Grantham’s view, while he allowed for the possibility that the rally could move still higher as the herd of institutions continue to panic, he also cautioned investors that the current rally would be followed by seven lean years. That’s seven lean years. He told investors who felt compelled to try and trade to be sure to measure out their capital and keep a good chunk of it in reserve so that when prices begin to fall once again, and the negative psychology returns, they will have capital left to go shopping with.
At the same conference, legendary bond guru Bill Gross of PIMCO, told investors that the current recession was ‘structural’ and it could take an entire generation (20 to 30 years) for the US economy to pass through this difficult phase. He spoke of an economy set to endure chronically higher unemployment (NAIRU – Non-Accelerating Inflation Rate of Unemployment) on the order of at least 7 to 8%, and likely much higher inflation in the years ahead. None of this is good news for the equity market, and all of these important bearish fundamentals are delightfully being momentarily placed aside by the herds mad-cap rush back into stocks. Of course, if individuals manage their capital in this manner, playing follow the leader, they won’t have capital to invest very long as institutional stock market psychology can change from one week to the next.
Speaking of crowd psychology, we can’t help but notice that investor sentiment has really continued to ‘bull up’ over the last few weeks. In my work, I track the Dollar Weighted Put to Call Ratio for Common Stocks in oscillator form, and believe it or not, over just the last few days this gauge has dropped down to some of the lowest daily readings of the last few years. There are times, for example in late 2006, when very low readings are a sign of a bullish kick off, and where the crowd is right. Yet more often than not, very low readings are a sign that a rally has matured and that a top is at hand. We also see the same kind of ultra bullish sentiment being reflected by the Investors Business Daily Call to Put Premium Ratio, which uses a more normal scale and resides at very high values at the current time. Perhaps even more importantly the IBD Call to Put Premium Ratio is sporting a bearish divergence, making a lower high versus its peak several weeks ago, and against the higher highs seen in the indices over the last few days.
Above: GST Short Term Put Call Sentiment Gauge – at extreme low values, a sign of intense bullishness. On this gauge the scale is inverse, with high values indicating panic/high fear, and low values indicating bullishness and optimism.
Above: Investors Business Daily Call to Put Premium Ratio GST Oscillator – a more ‘normal’
Scale, low values indicate fear and panic, while high values indicate bullishness and optimism. This gauge is also diverging in bearish fashion and it making lower highs against the highs seen a few weeks ago, and against the higher price highs seen in the last two weeks.
In addition to the flow of funds gauges shown above, the investor sentiment polling data is also at levels right now that are mission critical. In the case of our Sentiment Composite, which rolls up Investors Intelligence, AAII, MarketVane and Consensus Inc. into one indicator, the Composite is all the way back up to its declining one year upper band. This is no small potatoes and a similar outcome took place in the middle of the previous 2000-2002 bear market leading directly into a bear market rally peak. The gauge has also come back to the middle zero line which is often a line of demarcation between bull and bear market conditions. A lot will be gleaned from the market action over the next few trading days and over the course of the next few weeks as this is a prime zone from which a major correction should begin IF a bear market is still in force.
Above: GST Sentiment Composite Index with 1 year trading bands.
Above: Same gauge as shown in prior chart, just converted into an oscillator using %B which shows us that sentiment has come along way in a short period of time.
Next, to round out our parsing of the data, and I apologize for the blizzard of charts in advance, notice that if we Detrend the GST Sentiment Composite converting it into an oscillator using the Bollinger %B formula, that viewed in this manner, the full 180 degree turn in investor sentiment becomes blatantly obvious. Over the last decade or two stocks have been really hard pressed to hold these kinds of levels for more then a few weeks. Usually, this type of sentiment is seen either (a) at the start of a new bull market, or (b) at the very end of a major bear market rally. We will be straddling the thin dividing line between the two over the next few weeks. If the market does not go down and the indicator unwinds toward more neutral values, that will be a win for the bulls. Alternatively, if the indicator rolls over and prices correct meaningfully, that will embolden the bears. Much truly valuable insight lies directly ahead.
Another factor that I like to watch in tandem with analysis of Sentiment gauges is the action of other market internals such as breadth, volume, momentum. Usually if all of these gauges are acting well and making new highs in tandem with price, then excessively bullish sentiment is not a huge concern. However, when breadth, volume and price momentum are diverging negatively against prices AND Sentiment becomes excessive, that combination is usually a recipe for a one-two punch to the jaw. And big hurt! That seems to be the condition right now as internal market gauges have been steadily weakening for some time. Always an art and never a science, the only technique I know of in gauging this is a “weight of the evidence” approach. To that end, I start with NASDAQ that has been the rally leader and, even as I write this column, continues to reside at new higher highs to which I might add, unaccompanied by virtually any other major average (DJIA, SPX etc…).
In the chart above I show the Medium Term Money Flow Volume Oscillator for NASDAQ which peaked at a reading of +322 back on May 4th. Since then the oscillator pulled back and is now back up to fully overbought values at +161 as of last night, but is diverging negatively against prices. The same type of thing was seen back in 2006 when NASDAQ rallied off its April 19th lows and rose for a number of weeks before exhausting itself and rolling into a downside correction. As the top approached, Money Flow had been trailing off on the downside for weeks.
In the next chart I show a direct day for day comparison of these two rallies with the present day NASDAQ advance shown by the solid bold line. Against even its own prior history, this current advance seems to have come a very long way in a very short period of time.
Above: Aligning major lows. (Bold) the 2009 NASDAQ Advance, and in bar chart form, the 2006 advance. Has the current rally come too far, too fast?
In addition to Volume, the 21 day Advance-Decline Breadth Oscillator is now diverging against price, along with the 30 day OPEN ARMS Index and the 14 day RSI. We also note that while the NASDAQ A/D Line is still making higher highs, the gap between the A/D Line and its own 50 day moving average has been steadily narrowing over the last few weeks, and that is also a sign of deteriorating internals. On a very long term basis the current spread between the value of the NASDAQ A/D Line and its own 50 day average is still at levels rarely seen, hideously extended and therefore at levels that at least in the past have been very difficult to sustain. In my view, the weight of the technical evidence continues to suggest that the equity markets should be close to a downside reaction, a correction of real size.
Above: 21 day Advance-Decline Oscillator for NASDAQ.
Above: Daily A/D Line Detrended by 50 day average.
Above: NASDAQ A/D Line Detrend with upper demarcation line (shown as dashed horizontal line in prior chart), still at record values, territory that is very difficult to sustain.
Above: NASDAQ with 30 day OPEN ARMS.
Above: NASDAQ and the 14 day RSI (momentum gauge) by Welles Wilder.
While the vast pool of Central Bank liquidity (i.e. newly printed dollars) has kept these markets aloft and created a near impossible period for shorts -- in the near term -- the NASDAQ initial support comes in at the 1807 level while 924 is initial support for the SPX. Over the next few days any closes below these levels would be a first blush bearish indication that a downside correction of substance could be getting underway.
That’s all for now,
© 2009 Frank Barbera