Posted At : October 1, 2009 1:12 PM
Market Update – Risk level raised to opaque
Several things have me getting a little nervous, causing me to raise my threat risk color level to opaque. I admit, I don’t have a color system like Homeland security, but it’s not a bad idea. Although I do not think the rally is over, the change in color from the sanguine beige is warranted and a top could be in place at any time. Nothing has changed to make me feel that this rally is anything but a bear market rally and bear rallies are to be rented not owned. Since I went positive in early March, the biggest threat would be increased complacency.
(Investment Lesson 102: Investor Sentiment) The best indicators for this are investor sentiment numbers. The figures are a contrary indicator so when investors are negative the market goes up, and when they are positive the market goes down. The theory goes that as people become more positive and bullish, there are less people left to get in to continue to fuel a rally. What made me bullish in early March was the overwhelming pessimism, and it worked like a charm. Well the investor sentiment figures have been inching up and they are now at the highest levels since the rally began.
Futures traders appeared especially sanguine about the market’s ability to dodge a meaningful pullback. Both the Market Vane and Bullish Consensus poll figures showed high percentages of bulls, at 51% and 56%, respectively. This is the highest bullish percentage reading in the Bullish Consensus poll since June 5 and the highest bullish reading in the Market Vane poll since late May ’08, which marked the end of the first substantial bear market rally since the Oct. ’07 top. Individual investors are more bearish, according to the latest American Association of Individual Investors poll, showing 44% bears to 39% bulls. Those figures are neutral, at best. Short term traders also appear less than intimidated by the prospects for a further sell-off, as the CBOE equity put/call ratios have been generally in the mid to low .50’s the past few days, readings verging on overbought levels. Institutional hedging is increasing, however, as indicated by the S&P 500 put/call ratio of over 3.2 (put volume to call volume), well above the 21-day average of 1.7.
On balance then, individual investors are neutral, traders are optimistic and institutional investors are hedging—probably not the ideal scenario for a new long term bull market A red flag will be raised (unless I come up with a better color) when (not if) individual investors become more positive and thus complacent. For the time being, it looks as though the rally will continue as the market is absorbing the bad news very well. The pullbacks have been moderate on a daily basis, and volume has risen only on two of the down days so far for the past three weeks. If this was a year ago, and the market had received some bad news, the picture would have been entirely the opposite: we would have had triple digit losses in the Dow on very high volume.
Another concern is the timing and level of this rally. The initial drop in any Bear Market is often just a warning as it is very common to have a big rally off the low, only to make new lows. Right now we are at the 6 month point as well as the 50% retracement level. This is coming during the normally weak October season. This is important because in 1929, stocks first crashed by 48%, rallied back about 50% over 6 months and then fell to be down 89%! The timing is not an exact science of course but the outcome will be the same. I will be on the lookout for the warning signs that experienced technicians will notice, and right now the market looks resilient and any correction temporary. In fact, so much attention was focused on the negative September – October, which was usually strong this year because investors were talking about it, that it wouldn’t be a surprise for the decline to occur after everybody felt the danger was safely past and were on to the normally strong November to February period.
It’s important to recognize the stages of any and every market cycle. During the first stage of a primary market advance from a major low, Buying Power usually rises sharply, as buyers rush in to snap up bargains, and Selling Pressure drops sharply, as potential sellers decide to hold on to their stocks in anticipation of higher prices. This stage of expanding Demand and contracting Supply, which we call the “Primary Buying Zone”, usually represents the least risky period of an entire primary trend. Important market declines rarely occur during this first stage, and any periods of market weakness typically serve as buying opportunities. None of the “October Surprises” listed above occurred during the first stage of a primary uptrend.
In the second stage of a maturing primary uptrend, Buying Power continues to rise due to still strong Demand, but investors begin to take profits, causing Selling Pressure to reverse its earlier downtrend and begin to rise steadily, essentially chasing Buying Power higher. During this second stage of rising Demand and rising Supply, which we call the “Holding and Upgrading Zone”, investors should become more alert, since rising Selling Pressure shows that the risk/reward ratio is changing. Four of the nine “October Surprises” occurred during stage two.
As the primary market trend eventually nears its end, buying enthusiasm begins to wane, causing Buying Power to gradually turn down. At the same time, the initial profit-taking in Stage 2 begins to morph into distribution, causing Selling Pressure to continue rising. Thus, during the third stage, which we call the “Distribution Zone”, the earlier positive relationship between Buying Power and Selling Pressure begins to weaken, showing that the risks are significantly increasing. Five of the nine “October Surprises” occurred during stage three.
Regards -Keith Springer