The market scenario I chose last time in "Push Comes to Shove" remains in place. I think the market is working its way toward an intermediate term high which will result in a larger correction than we have seen since March 2003. Furthermore I think that high is likely to be in December or early January. I'll review the evidence.
The biggest piece of evidence is also the most recent. Long before I traded stocks, mutual funds, and stock index futures I was a commodity trader. One of the best of all sentiment measures is comparing the net futures (and futures options) positions of the insiders with those of the speculators, large and small. Futures exchanges were first set up in Chicago in the 19th century to transfer risk from producers and banks to speculators. Guess who is most often right about danger ahead (and therefore putting on short hedges) and who is wrong?
My "pay for" guru on this subject is George Slezak http://www.cot1.com/ But you can read the weekly results for free from the US Government: http://www.cftc.gov/cftc/cftccotreports.htm The big change is that the knowledgeable players, the commercial hedgers, also known as the insiders, have switched from a major long position at the October lows of six weeks ago to a major short position as of this last week. This is compelling news.
Other sentiment as I measure it, and as measured by others, is into a zone which has sent the stock market down over the past two years. We've had two or three short term tops in both years at new bull market highs or near new highs. So unless "it's different this time", there should be a decline before too long. What could make it different is what last month I called the "bullish wild card", which is that the markets breakout and run up in a new bulish leg like that one of 2003. Part of my sentiment studies depend upon interpreting VIX. The CBOE's White Paper on VIX is a good place to start to get up to speed: http://www.cboe.com/micro/vix/vixwhite.pdf
A chart from that White Paper shows the basic usefulness of VIX:
(Click on the image for a larger pop-up version.)
CBOE began publishing VIX in 1993 using options data back to 1990. I think of VIX as a fear index which goes up when market players are worried enough to pay up for hedging insurance, and goes down when they are more confident without insurance. This is a gross oversimplification
but it works for my purposes.
In 1990 Saddam Hussein invaded and planned to annex Kuwait, and later set fire to its oil fields as he withdrew. In addition to changing the course of history, which continues to this day, these events shocked the stock market at the end of the decline from 1987 and the savings & loan implosion. VIX rose to high levels as stock portfolio managers and others rushed to hedge short or sell short. During the subsequent bull market from 1990 to 1994 the SP500 rose from just under 300 to 480, and VIX "fear" dropped from near 40 in 1990 to between 10 and 15 from 1993 to 1996 with occasional drops under 10. In 1996 the stock market corrected and then began the great bullmarket into 2000. But unlike 1990-96, VIX began to rise on a trend basis with the price of stocks.
With VIX hovering around 10 recently, what could "be different this time" if the stock market really begins to take off along the lines of the 1935-37 scenario presented in October and November? This is how some analysts, including me, who use sentiment measures which utilize VIX and put/call ratios could get fooled. Sentiment has become very popular, but it could be entering a period of time when it will be less useful than it has been since the 1990's. The current very low sentiment readings, which have characterized stock market highs for two years, could rise but could do so either because stocks break down or up. Also, if the market breaks upward we could see what is called a "recognition wave" when the majority would be right that the market will rise further, so even polls and other methods of sentiment would get fooled.
For this reason older market analytical methods like the NYSE advance/decline line and other volume and breadth indicators may be more important. We are seeing some of these indicators begin to evidence a slowing of the advance. The advance/decline line has turned down in the past few months. It's certainly not a timing method as many shorts learned painfully in the 1990's, but it's a hint of a change. Likewise the "last hour versus first hour" or "Smart Money Index" has been falling for a year now which indicates distribution by the "smart money". Notice how the market often opens up in the morning because of enthusiasm, but frequently sells off in the last hour or half hour.
While they aren't infallible, they have been around a long time, and the Lowry Report people have been seeing multiple indicators suggesting a larger pullback in the market. I won't get into economic indicators in detail, but GDP was revised upwards although a lot of other factors are rolling over. Review the post in October on some of Paul Kasriel's indicators, or read some of John Hussman's weekly posts. www.hussman.net/index.html
I have increased short hedges on stock and mutual fund positions and have reduced holdings of some inflation hedges. I'm still net long and hoping to increase hedges gradually into year end rallies. Some neural network folks I know who have been doing this work since 1996, are projecting a decline for the next week or ten days. This would fit with the SPX and DOW seasonal patterns which go back to 1949 and 1928 respectively. These are just statistics, not promises, but the market often declines into mid December and then the Santa Claus rally takes us to year end.
I will begin to see that I am wrong if we have a large advance of several days with VIX rising instead of falling.
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