The Fed Has Succeeded

The Investment Company Institute reported this week that for the first time in almost a year, there has finally been an inflow in domestic equity funds. All the major sentiment surveys are at extremes, and this new data point confirms that The Fed has succeeded in finally getting the retail investor to put his last dollar back into the market, allowing insiders to sell their remaining stakes at lofty prices.Insiders have been selling almost every single week at a clip of several hundred to one. Meanwhile no major investment outlet has a sell on the stock market for 2011. How can it be that the people who run these companies, with about as much inside information as you can get, are selling hand over fist, yet almost all analysts have been upgrading their market outlook? This new data point does not pass the smell test, and only confirms the myriad of other red flag signals popping up all over the place.

Chart 1: ICI Fund Flow Data

The Charts You Need to See Before 2011, Part 1

I hope everyone is enjoying the holiday season, a new year is upon us, and as we approach 2011, I thought I would just post up to date charts of some indicators that I feel are worth looking at.

Chart 1: VIX vs SPY

I wrote about the VIX recently when it started to flirt with levels that typically mean 1) investors are complacent regarding risk 2) declines of various magnitudes have followed. I've outlined here some instances in the last several years when the VIX has gotten to similar levels and the reaction in the stock market. While we are talking about the VIX, I might as well update the other valuable option indicator; the put call ratio.

Chart 2: Put Call Ratio vs SPX


I've calculated and added a 1 and 1.5 standard deviations as well as a 10 day moving average. The nice thing about the put call ratio (compared to the VIX) is that it can give you buy signals as well as sell signals, such as the buy signal in June, or some 200 S&P points ago. Now however, like the VIX, it is signaling that investors are overly optimistic and complacent. I've highlighted some previous examples of when conditions were similar and an almost immediate sell-offs occurred.

While discussing the put call ratio it makes sense to also review some of the other sentiment indicators, namely the Investor Intelligence and American Association of  Individual Investors.

Chart 3: Investors Intelligence

The bull bear spread is reaching generally bearish levels. I've highlighted some of the other recent instances when the spread was this large between bulls and bears, all of which preceded corrections of various degrees, included the top in 2007. Advisers, who blew monumental opportunities to sell the 2007 and buy the 2009 bottom are back at it again. After a record run in stocks, now they are bullish. Individuals seem to agree, see the below chart.

Chart 4: American Association of Individual Investors

 

Another look at the current McClellan Oscillator. 

Chart 5:  McClellan Oscillator vs SPX

I prefer to sell the market when the McClellan is much higher, however sometimes I have seen divergences, which usually occurs right before intense, fast declines, such as in "Flash Crass." You can see the divergence develop in the chart above. The McClellan got very overbought and then a huge divergence developed, seemingly with no market reaction, then the market dropped suddenly in May. More recently, starting in August, the McClellan has possibly been diverging for months. While one can make the argument that the market will continue to rise until the McClellan is overbought, which normally I would agree with, but the summation index also shows both a large long term divergence, and a short term small divergence between this and the previous most recent peak. This makes me lean towards the bearish interpretation.

Part II coming in a day or so.

Market Breadth Continues to be a Problem

The drones on CNBC continue to talk about breadth seemingly without any understanding of what they are talking about. Bob Pisani continues to impress upon his viewers his wisdom with such gold nuggets such as, "Some traders think breadth is bad, others don't (I paraphrase here but you get the idea)." The reason breadth is important is breadth can tell you how far along a trend is. During market bottoms most stocks are participating as selling climaxes. Tops in the stock market on the other hand tend to be much more rounded; fewer and fewer issues participate as hope dissipates and buying power is exhausted. So when the market average starts move higher with fewer stocks participating, that can be an indication of an upcoming correction, even top.

I've posted several charts here of the McClellan Oscillator and Summation Index, some of my favorite studies to look at, and very predictive in my opinion. The divergences that I've pointed out continue, and while the indicators could always turn and reconfirm the uptrend, that just seems beyond what is possible in my experience.
Chart 1: McClellan Studies

The McClellan studies continue to show that momentum in breadth actually peaked months ago, and there are multiple divergence at both large and small degrees. Another way to visualize the breadth of the market is too look at the absolute breadth index, which is the percent change in the absolute difference between advancing  and declining issues.
Chart 2: Absolute Breadth Index vs SPY

As I mentioned, lulls in breadth tend to happen near corrections. I've added bands that represent 2 standard deviations from the 200 day mean. We can see from the chart that every time breadth dropped below 2 standard deviations from the mean, short term tops followed almost immediately. Not only has the indicator dropped to that level, and has fallen further than previous drops, but also occurred concurrently with a host of other technical indicators indicating a correction is near.

A Merry Christmas or a Lump of Coal?

All major sentiment surveys, the S&P dividend yield, the Shiller PE ratio, and cash levels at mutual funds are telling us the same thing; investors are the most optimistic they've been in years. In my experience the next long term move is never obvious to the investing public. When the herd get's bullish, I want to start thinking bearish (and vice versa).

Two of my favorite studies to look at are the put call ratio, and the McClellan oscillator/summation index are showing bearish conditions, similar to the May flash crash.

Chart 1: Put Call Ratio

 The put call ratio's 10 DMA has crossed over the 1 standard deviation line (the setup) and may have crossed back (the trigger). I say "may" because depending on the close over the next day or two, if they are extreme on the call side, it could temporarily drag the moving average back into the setup area. Regardless, the message is the same, speculators are betting heavily on the upside after the run has already taken places, and longs are not hedged and unconcerned with a decline.

Chart 2: McClellan Oscillator and Summation Index

Usually I like to sell the market when the 5 day moving average is much higher and turning back down through the 1 standard deviation line. However, a few times I have seen moves continue despite a rolling over McClellan, but when the market finally does change direction, especially when sentiment is peaking, the resulting move is generally fiercer than usual. Note in the above chart that not only is there a rolling divergence, much like the one that occurred right before the "Flash Crash" but this divergence is actually even larger and longer running. Not that this guarantees large downward move, but it is interesting to see this phenomenon again with the same reading on the put call ratio.

A new addition to the list of sentiment indicators reaching extremes is the VIX, which recently fell to 15. This confirms the put call ratio's signal and furthermore upgrades the significance and importance of the signal.

Chart 3: VIX

We can see from the chart here that the VIX is at extremes that it hits maybe only once or twice a year. The VIX is essentially what investors are willing to pay in terms of insurance on stocks. Clearly, investors are not worried, which is ironic because lulls in volatility precede spikes in volatility, in lay terms, the time to buy house insurance is BEFORE your house burns down, not after.

The Setup Looks Bearish

Besides the put call ratio looking ever more bearish, the McClellan oscillator and summation index continue to show huge divergences. When I noted this a week ago, the NYSE and Dow were not following the S&P and Nasdaq to new highs, though since the have followed to marginal new highs. That said, the divergences are so large my feeling is they must mean something, especially with sentiment at the requisite level where I would begin to expect a trend reversal.

Chart 1: A quick glance and the NYSE

 While the closes are still above .8 standard deviations above the 10 day mean (bullish price action) we can see from the RSI that there is a bearish divergence in momentum. Volume continues to be an issue, and has receded, especially during last two weeks.

The McClellan oscillator and summation index are some of my favorite technical studies to look at. It surprises me to see how little utilized they are considering its predictiveness, especially in combination with just a few other tools. I honestly believe one could trade successfully by looking at this study alone. That said, lets see what it is telling us now.
Chart 2:

Two areas of concern here. One, McClellan is showing us not only a divergence in a daily degree (showing I divergence between this peak and the peak in November), but,  two, also a large divergence between this rise and the rise in August. This could indicate that the entire sideways gyrations for the last several months are corrective in nature, not a break out, and the impending correction could be larger than most expect.

When most people discover oscillators from a book, website or whatever, they note that divergences almost always appear at turns. Well that's because books only show examples of of turns. In practice/reality people discover that divergences appear all the time, then can disappear as prices continue on there way. I would say a high percentage of divergences are meaningless (especially in momentum). The correct way to use them is in concert. When divergences in price, momentum, and breadth occur together, and at a sentiment extreme, then however you have a very high probability setup, and that what trading is all about. Folding the low probability setups, betting on the high ones.

So lets review:
The closes of the major indexes continue to eek out gains. Sentiment by almost any measure is very high. Some measures show sentiment to be at multi-year highs and the put call ratio is generating a sell signal. Momentum is lagging and showing divergences. Breadth is lagging mightily and showing large divergences in both weekly and monthly peaks. Prices may continue higher, but I would not bet on it.

Market Sentiment, continued...

The one thing you do not want to see if you are bullish on stocks is a strong consensus that stocks will go up. The crowd is usually wrong, and the bigger the crowd, the more wrong they get. Right now the crowd is getting pretty big. The way I like to explain it to people is this. What is a trend in a financial market? In its simplest terms its people changing their minds from one direction to another. So lets say that the entire stock market is only made up of 10 people. By the time the 10th person buys, prices literally cannot go any higher. There is simply no one to bid prices higher. While this example obviously simplifies the task of determining how many people are committed to one side of the other, there are various measures which one can use to gauge how far along the trend is.

Chart 1: Investors Intelligence Survey
Courtsey of Market Harmonics

Percent bulls is certainly at the highs of the range, and percentage of bearish respondents is quickly drawing near the danger level as well. This is not what the sentiment backdrop would look like if this was the start of a new rally leg, as most are claiming, but in fact the opposite. The American Association of Individual Investors is showing a nearly identical reading, with 53% responding bullish to last weeks poll, 14 points above the historical average.

Also interesting is the last week commitment of traders report for the S&P e-mini. I like looking at the commitment of traders report because one can easily make a direct comparison between large trader and small speculators. Small speculators tend get it wrong, especially at turns, while large traders tend to be positioned correctly.
Chart 2: 

What's interesting here is while most of the sentiment surveys show a bullish consensus, large professional traders have actually accumulated a large net short position in the S&P e-mini. In fact, it's the largest net short position that they have held in over two years, and right before the market took a nose dive in late 2008.

The Put Call Ratio, continued...

The major market indexes are at new highs for the year, and continue to close above .8 standard deviations above the 10 day moving average; so there is no bearish sell signal yet, however sentiment according to a variety of measures has once again gotten extreme indicating that the money to be made in the next few weeks ahead will be on the short side. Further strengthening this argument are divergence in indicators or breadth and momentum.

As I've been noting a for a week or so now, the put call ratio has been signaling that we should expect a correction soon. As the 5 DMA worked it's way back to the one standard deviation mark however, I wrote that I expected another setup to emerge, which we are seeing now.


Chart 1:  Total Put Call Ratio - 5 DMA

We can see here that speculators are pouring into calls. The signal line (5 DMA) is only slightly in the setup area so it may very well get even more extreme. That being said in my experience these kinds of speculators are wrong 99% of the time. It's always amazing for me to see that after the rally, people want to bet on the upside, after the move has already happened. 

I also mention previously that I will also look at the 10 DMA of the put call ratio, which will sometimes weed out some of the false signals that can occur right before a true signal.

Chart 2: Put Call 10 DMA

Using longer time periods has it's advantages and disadvantages. While it may weed out some bad signals, it can also weed out some good ones, like the buy signal that occurred in early September. In this case however it would have weeded out that false sell signal that occurred in mid November. I actually consider that "false" signal to be part of the same setup, but back to the chart, we can see that there have only been 3 signals this year including this one. One in January and one in April, right before the flash crash. Both signals lead to very fast declines, and currently the 10 DMA is in a similar spot to where it was right before the flash crash. As always, an extreme signal can always get even more extreme. But what this does tell you is being long is no longer a smart bet.

The Put Call Ratio Gets Interesting

Signals generated by the Put/Call ratio have been very accurate this last year. It doesn't speak often, maybe a few times a year, but when it does, it pays to pay attention to it. A few days ago I wrote that several indicators of market sentiment had gotten quite high, including the 5 day average of the put/call ratio. Calls are leveraged bullish bets (strong belief market will go up) and puts are leveraged bearish bets (strong belief markets will decline). When the 5 or 10 day moving average reaches one standard deviation from the mean, the signal is highly contrarian; in the short term speculators are so convinced they are using leverage. In my experience this is almost exactly a turning point in the previous trend.

My personal put/call setup is a long term mean of one day closes of the put/call ratio. Then I calculate 1, and 1.5 standard deviations from the long term mean. Signals are generated when either the 5 or 10 day moving average crosses beyond the 1 or 1.5 standard deviation lines, then cross back, indicating a turn in sentiment is occurring or is imminent. That being said, lets look at the put/call ratio and where it stands today.

Chart 1: Total Put Call Ratio $CPC

 

In November the 5 day moving average indeed crossed the signal line then back, indicating short term sentiment was indeed running high. The broad market did pull back, but the previous signal in mid-November seems to have failed. But now the 5 day average is back in the signal area, indicating that in the near term, the market is saturated with Bulls. I will be watching to see if this signal get even more extreme, possibly enough to drag even the 10 day moving average below the signal line, which would be a very bearish setup.

An Xtranormal Discussion of Ben Berneke's 60 Minutes Interview

Video Link: http://www.xtranormal.com/watch/7975773/#

Monday, December 6, 2010 - Market Wrap Up

Momentum:
First, the market continues to close above .8 standard deviations above the 10 day moving average. While the indexes appear to be threatening the high, stochastics are overbought, and the fisher transformed momentum oscillator maybe showing a large divergence. Furthermore, what is interesting is that DeMark indicators are showing perfected sell countdown signals on both daily and 4 hour charts simultaneously.

 

Breadth:

Breadth is also showing some divergences both long running as well as a divergence between the last peak. Looking at the NYSE McClellan summation index it's quite clear that breadth actually peaked out some months ago. Looking at both the oscillator as well as the summation index we can also see a large and visible divergence between this most recent peak, and the previous peak in November. 

The NASDAQ McClellan oscillator and summation index look similar, showing the same divergences, this significant because while the NYSE is not at new highs, the NASDAQ is. If the Summation index and oscillator do not set new highs in short order the bearishness of this divergence increases.

Similarly, the NYSE closing tick, while not showing a sell signal, may also be showing a long running divergence as well as a possible divergence between this current rise and the previous peak. 

Generally, it is not recommended to trade on divergences, since they can simply disappear as price continue to rise. However, as I mentioned in the previous post, sentiment is running very high, so possible bearish signs should be given more weighting. Divergences happen and often times are meaningless, however they almost always occur at turns. So when divergence occur in momentum, breadth, and concurrent with a high degree of optimism, one should be on extra alert.

Market Sentiment: Are we Getting Too Bullish?

Overview:
The most dangerous thing in the stock market is a strong bullish consensus, a point that we maybe rapidly reaching. Let's take an objective look at the current market sentiment.

Long Term Sentiment:
A good gauge of long term sentiment includes the level of cash at mutual funds and the dividend yield on the S&P 500. Currently, cash at mutual funds stands at 3.6%, reaching a record low a few months ago at 3.4%. This is a level that has been reached only twice, in 2000 and in 2007, which turned out to be important highs in stocks. Currently the dividend yield of the S&P 500 stands at only 1.83%, near it's all time record low. Long term investor's are so certain of future capital gains, they literally do not want to be paid cash in hand.

Chart 1: S&P Dividend Yield
Courtesy of  http://www.multpl.com/

Intermediate Term Sentiment:
There are several sentiment surveys that generally provide a good view in the intermediate term sentiment, and become very predictive once they reach extremes. The American Association of Individual Investors currently stands at an elevated 49.66% bulls, even reaching 57.56% three weeks ago. Investor's Intelligence Adviser's survey shows a similar sentiment picture, last week recording 55.4% bulls. These are extremes not seen since 2007.

Short Term Sentiment:
The Put/Call ratio has reached a point where one would expect, in the short term a correction.

This has been a reliable short term setup; the 5 day moving average of the total put call ratio has reached one standard deviation below the mean (the setup) and has since crossed back above the one standard deviation mark (the trigger).

Summary:
In short, we have long term investors, intermediate term investors, and short term speculators all taking the same side of the trade at the same time. When everyone agrees, the opposite thing will always happen. Seeing as how these indicators are aligned the same way in which they were in 2007, caution is definitely warranted.

Bullish On the US Dollar Index

Bulls in the US Dollar have all but disappeared, which as always makes me take notice. The most predictive indicator of a trend change is an extreme consensus, which we now have in terms of the dollar's fate. The investment community has resigned the dollar to slow death by Berneke. Ironically, QE2, which should have been the death knell of the dollar instead sparked the dollar back to life, sending the dollar strait up. While fundamental analysts must have been scratching their heads at this, the technicals at that period looked very encouraging.

Chart 1: UUP Dollar Bull ETF (Click to view full size)

The QE2 announcement occurred near annotation A. While that should have sent the dollar crashing, instead, occurring with an extreme in bearish sentiment, a perfected TD-Sequential, TD-Buy Setup was recorded. The "look" of the decline appears to be a large 3 waves of momentum or an ABC correction, implying that the trend at one degree higher is up. Looking at annotation B and C, negative directional movement (-DMI) as well as the average directional index (ADX), and disparity between the close and the 200 DMA all became extreme, reaching levels that, in the past, have occurred at trend reversals. In fact, the last time these indicators became that extreme was in late 2009, which preceded a huge multi-month rally. At annotation D, we see a momentum sell signal that is very short, and barely breaks the lows, which is then immediately reversed  at annotation E by a momentum buy signal that takes out the highs of the previous momentum buy signal, a generally reliable signal of trend reversal.

That being said the UUP has rallied sharply, with many indicators of momentum registering overbought levels; a correction should now be expected, though position traders should use the correction to get long the dollar index with a stop just below the November 4 lows. Looking at a 4 hour chart we can get clues as to when to expect an end to the current correction on a daily basis. 

Chart 1: UUP 4 hour bars (Click to view full size)

 The current TD-Sequential TD-Buy Setup count is currently at 6. In terms of momentum, fast stochastics is reading oversold. Momentum is still in the middle of the range but falling. I'll be watching for oversold levels, fast stochastics to turn upward, and possibly a completed TD-Buy Setup, possibly in the next few days.