Equities: Sentiment Overview - Part II

Note: Instead of answering individual emails about sentiment, I am continuing the topic which tries to cover majority of the important indicators for a possible intermediate bottom. Please note that equities still remain in a secular bear market that started in March 2000. Tail risks include real world economic events such as a crisis default event in EU and Chinese property market crash or various other themes you read on front pages of newspapers every morning.

The the first part of this two part post was written last Tuesday (Article: Equities: Sentiment Overview - Part I). If you haven't read it yet, I highly recommend you start there first and come back to this article afterwards. I've covered a lot of sentiment indicators in Part I including volatility, sentiment survey's, hedge fund performance, options, insider activity, analyst sentiment, fund flows and many more. Therefore, before I start, I will do a mini update on how these indicators are progressing since last week - it seems that last weeks post wasn't enough for some.

• Volatility remains elevated. Last nights close was above 45 and now we are testing to see if we will go higher than 48 we hit on August 09th. A new low in the S&P 500 towards 1040 support without a new high in the VIX will be a positive development. A new high in the VIX would not be a negative indicator either, because standard deviation wise, VIX spends only 3% of the time above the level of 40.

• Certain sentiment survey's became more bearish last week and one of the more noticeable ones was Fund Managers long exposure (NAAIM). Managers seem to have capitulated last week reducing their long exposure to 4%. As we can see in the chart above, these market Pros" were 80% plus net long couple of quarters ago. Hulbert Stock Newsletter Sentiment now shows a reading of -16.8% net short exposure, same as March 2009. In other words, newsletter advisors are now recommending to short the market. How thoughtful!

• History shows that bearish seasonality tends to end in October. Even though some of the worst crashes occur around this time of the year, October is still a “bear killer" and there is a lot of bears to be killed right now! Since World War II, 11 bear markets were turned around or ended in October including 1946, 1957, 1960, 1962, 1966, 1974, 1987, 1990, 1998, 2001, and 2002. Emerging Markets as well as Nasdaq also bottomed in October/November of 2008 as well, while S&P 500 took a bit longer due to the financial sector.

• Short interest jumped in middle of September to the highest level since March 2009, according to New York Stock Exchange data. Total NYSE short interest was 15.69 billion shares as of Sept. 15, up 5.4% from the end of August and up nearly 18% from the end of July, when the market was building the "right shoulder".

Contrarians should definitely take note of these developments (and many more) as we get closer and closer to an inflection point. Now lets get into Part II - Breadth.

Selling Volume

When we average the NYSE Down Pressure readings over the last 10 days, we can see that we are once again reaching an extreme we last saw on August 09th (chart below). These types of readings, especially more than one occurring in a short period of several weeks or months, usually signals some type of intermediate bottom.

Also consider that 5 of the past 10 days saw down volume make up 90% or more of all NYSE volume. That might not sound like such a scary thought to you, but in the past 62 years only three other time periods come even close to matching this type of extreme down pressure. You might become a bit more interested now and ask me what periods were those? Well, the first two occurred before I was born and I was a baby to remember the last. The dates were August 1943, October 1978 and October 1987 (see... Octobers once again).

So some of you now might might ask, what happened afterwards? According to history (and it is just three cases only) during the next month, next three months and the next six months, the S&P 500 edged out a positive return each time.

Advance & Declines

There are a lot of ways an investor or a trader might use Advances and Declines. The more popular indicators such as Cumulative AD Line, McClellan's Oscillator, McClellan's Summation Index and a 10 Day Advances minus Declines. I could also put up various charts I do myself, but it is not necessary. Basically, consider the simple chart below:

It is the 21 Day AD Line. I prefer to use this because my perspective is not that of a trader or a short term swing speculator. Usually intermediate bottoms occur when the overall index itself makes new lows and yet the Declines do not outnumber Advances, like they did on the first trough.

So for example, the recent stock market crash bottomed into 09th of August with 21 Day AD Line hitting a reading of -800. That means over the last 21 days, we have had 800 more Declines compared to Advances on average per day. Now the S&P 500 is making a lower low towards 1040 support area, and yet AD Line is diverging. This is a bullish divergence and it lets us know bears are slowly but surly exhausting themselves. As a side note, not on my blog however, as some are still posting super bear deflationary collapse links everyday.

Arms Index (TRIN)

So we just covered Volume and Advances vs Declines. This is where Arms Index or TRIN comes in handy. Created by Richards Arms long time ago, this is a great indicator to follow overall breadth momentum. Basically, despite its somewhat technical name, it is very simple - the indicators job is to find a ratio between Advance Decline Breadth and Up Down Volume. I tend to use a 21 day (one month) average for these readings, because I am not a trader majority of the time.

As we can see in the chart below, neutral readings are at 1.00, but as of late, these readings are slowly moving towards 1.20 majority of the time. Readings lower than that tend to signal a lot more advances than declines and a lot more up volume compared to down volume. In other words a lot of buying, a lot of complacency and a lot of optimism. On the opposite side of the spectrum, we should pay attention to readings that go higher than 1.50 or even as high as 2.00. These readings show us that there are a lot more declines and a lot more selling pressure in the volume. These times are associated with dumping of stocks due to fear as many start to forecast the awful economic conditions ahead - and there are plenty of them around now!

Currently we just hit a reading of 1.95 of the last 21 days. Lets put that in perspective over the last decade or so and see what other major stock market collapses managed to produce when averaged over 21 days (one month) of TRIN:

• May 2010 flash crash reached 2.10 twice
• Post Lehman 2008 crash reached 1.87
• World.com 2002 crash reached 1.55
• September 11th 2001 crash reached 1.47
• LTCM crash in 1998 reached 1.18

The current sell off is very extreme to say the least, and while it could continue for awhile longer without a doubt, this type of intensity is associated with panic and not complacency. I have to underline this point, because there are many novice investors who believe we are in a period of "complacency". I guess the old saying states that it is not what you look at, it is what you see!

52 Week New Highs & Lows

A large number of 52 Week New Lows tends to create an oversold condition like we had on 09th of August when S&P 500 fell to 1100. However, that does not necessarily bottom the overall market. It just creates an oversold bounce. For the overall market to bottom, we need to see lower index price while we have less and less 52 Week New Lows occur. In other words, bears are exhausted and are struggling to push the majority of index components lower. As fewer and fewer components keep making new lows, eventually the index itself regains strength to turn around and stage a real rally, not just a small bounce... and we are just about there now.

Percentage Of Stocks Above MAs

This indicator can also be used in many different ways, shapes or forms. You have traders looking at the short term side of things with Stocks Above 10, 20 or 50 Day MAs; or you have investors looking at the long term side of things. And than you have your basic divergences, which can be followed too.

Once again, I try to keep it simple. Basically, the way I like to use this type of indicator is with the Percentage of Stocks Above 200 Day MA. If you study history of market breadth in any major post World War II crash, you will notice that when breadth becomes extremely oversold like in the chart above, usually it marks a bottom - at least an intermediate one. Currently we are in that oversold area once again with a reading of only 14% of stocks above 200 MA within the S&P 500.

The more time we spend here, the more oversold the market becomes and better the probability we have as contrarians in buying an up and coming bottom. During the Financial Crisis of 2008, this indicator spent over 6 months at readings below 10, so we are not as oversold as some truly historical events. Sector and industry wise, in alphabetical order, readings are as follows:

• Biotech has 18% of Stocks Above 200 MA
• Discretionary has 14% of Stocks Above 200 MA
• Energy has 0% of Stocks Above 200 MA
• Financials has 2% of Stocks Above 200 MA
• Gold Miners has 15% of Stocks Above 200 MA
• Health Care has 16% of Stocks Above 200 MA
• Housing has 5% of Stocks Above 200 MA
• Industrials has 4% of Stocks Above 200 MA
• Materials has 7% of Stocks Above 200 MA
• Semiconductors has 0% of Stocks Above 200 MA
• Staples has 25% of Stocks Above 200 MA
• Technology has 5% of Stocks Above 200 MA
• Utilities has 55% of Stocks Above 200 MA

If I was going to buy something, I definitely know what I would be buying - and lets just say it would not be Utilities!

Crash Analogue

When the Volatility Index spikes, it takes awhile for the prices to calm down and establish a bottom. That is what sentiment and breadth help us achieve. Another way to do that, is to look at previous historical capitulation processes.

In the chart above, I have my own Crash Analogue, which follows the S&P 500 price just as it starts crash - in other words just as the VIX starts to spike. In all the cases above, S&P 500 declines about 20% on average before staging a rally. Investors forget that markets correct with both price and time. In 2001, the index decline the most and in the quickest time frame, while in 2010 the index declined the least but in the longest time frame. Currently, we following similar bear market patterns of 1990 Savings & Loan Crisis and 1998 LTCM / Russian Default Crisis. Note: Certain extreme cases have been removed from this study. The study of all the crash analogues can be found here.

Technicals

I don't really focus on Technical Analysis and do not really believe in it too much. Here, I just want to highlight the basics, which many would already consider common sense. There is basically a strong support - in other words buying memory of investors - on the S&P 500 at 1040 level, plus the 1000 level. Also, 1000 is a psychological round number, which tends to reenforce this opinion even more. Look for the index to find a lot of buyers between this polarity.

Summary

Just because I wrote this article today, does not mean one should automatically buy S&P 500 futures right now, right here. This is just information, which could help you make a decision, whatever that decision it might be, whenever that time comes. No one is putting a gun to your head and telling you to buy stocks right now, and it does not mean a bear market could not continue lower if one of Chinese banks were to blow up tomorrow due to property price declines. Also of important note is that, S&P 500's 200 day moving average is now point downwards. Usually these indicators work better when this line is pointing upwards.

But at the same time, do not get carried away with fear and bearish arguments, which try to convince you from an academic point of view on how we are following in the path of Japan - a prolonged black hole of deflation and falling prices. Investing has nothing to do with academics. You best leave that for analysts, economists and professors, majority of whom just work for a wage.

Finally, I came across this and I thought I would share it with you. At the end of last month, CNBC was asking its viewers if they believe the economy is now heading into "depression". In my opinion, it doesn't even matter what you believe the answer is, just the question itself is enough of a contrarian indicator...