Tuesday, November 6, 2012

Sign Of Capitulation: Are We There Yet?

Market Notes
Source: Merrill Lynch
 Source: Skandinaviska Enskilda Banken (SEB)
Source: Short Side Of Long
  • The latest CFTC Commitment of Traders report showed that Small Speculators, also known as Dumb Money, are shorting Sugar as of Tuesday of last week. At the same time, the Daily Sentiment Index (DSI), a measure of optimism from futures traders, is approaching single digit readings. From a contrarian point of view, these sentiment readings indicate that Sugar could be close to an intermediate bottom. Furthermore, as already discussed in a recent in-depth article, Sugar's prolonged bear market, which  is currently almost two years old, is creating a good demand & supply equation as farmers cut production, while demand returns with price down more than 45% from the February 2011 peak.
Source: HSBC

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        It has come to my attention that various market participants are calling for the end of a correction. The majority of the CNBC & Bloomberg crowd, usually consisting of various fund managers, has declared the correction over. They claim that a run of a mill 5 to 7% correction has now run its course and it is time to buy back in as the bull market continues. From what I have been reading coming out of investment banks like UBS and Merrill Lynch, technical analysts are also claiming the same. Finally, various bloggers aren't too bearish either, as they see stocks currently oversold and bottoming in the coming days or weeks. From everything I track, I do not think there are any major signs of capitulation yet. Let me explain.

        I personally believe there is no holy grail indicator or tool out there to tell us when the market is in capitulation mode and about to bottom out. At least I haven't found one just yet, but if you have - make sure you email me immediately (but do not tell anyone else haha)! Therefore, what we need to do is put together a lot of sentiment and technical indicators to see if and when they confirm each other. When the majority of basic indicators signal oversold and over pessimistic conditions, most likely it pays to be a contrarian. Just as the annoying kid consistently asks his parents that infamous question, we too want to know, "Are we there yet"?
        Source: Short Side Of Long

        One of the easiest and most straight forward ways we can see that the market has witnessed a fear or panic capitulation moment is by tracking the ever popular Volatility Index, also known as the VIX. A weekly closing spike above 35 usually does the job. Verdict: in my opinion we are not there yet.
        Source: Short Side Of Long

        Furthermore, I personally think that the VIX still remains in the so called danger zone. This means that the current market conditions are described as very complacent, which usually signals an intermediate top instead of a bottom.
        Source: Merrill Lynch

        Global volatility indices for other asset classes also show a similar picture. It is as if the markets have paused for the time being as US and China roll through their leadership changeovers, before we get back to business. Global equity volatility, foreign exchange volatility and commodity volatility are all at their lowest levels since at least 2007. In my opinion, this is a very worrying signal.
        Source: Short Side Of Long

        Connected very closely to volatility are various credit spreads in the bond market. My personal favourite is the spread between Merrill Lynch High Yield and equal maturity US Treasury Bond known as the ML High Yield Master Index. With spreads back to May 2011 lows (last equity market top) and Junk Bond yields at record lows, trouble could be brewing ahead. Verdict: in my opinion we are not there yet.
        Source: Short Side Of Long

        Investment advisors are also not too worried right now. Recent Investor Intelligence Bear readings have remained at complacent levels for months and months... and months. This is usually a signal that we are closer to an intermediate top rather than a bottom. Verdict: in my opinion we are not there yet.
        Source: Short Side Of Long

        Confirming this view are various cash level readings of market participants. One of my favourites to track is the AAII Asset Allocation survey, which comes out once a month and is a less volatile measure than the weekly survey. With cash levels of retail investors falling to the lows of May 2011 (last equity market top), I think market participants are just way too complacent. Verdict: in my opinion we are not there yet.
        Source: Short Side Of Long

        Another way to track what retail investors are doing, instead of thinking, is to look at the fund flows at the Rydex funds. One of the most popular measures of market sentiment is known as the Nova Ursa indicator and for the last few months, it has been signalling investor's appetite for stocks, which is very high. Looking at the chart above, it could be said that we have been given a contrarian sell signal with an intermediate top in place. Verdict: in my opinion we are not there yet.
        Source: SentimenTrader

        Generally, the risk appetite has been extremely strong since July 2012, as we can see in the chart above thanks to SentimenTrader website. Investors everywhere have been chasing risk assets due to various fundamental and technical reasons. This has created a group think mood of stock price extrapolation into the future. On the other hand, the chart above signals that the risk appetite readings could most likely be a contrarian sell signal. Verdict: in my opinion we are not there yet.
        Source: Index Indicators

        Moving away from various sentiment readings, the stock market internals (breadth) are also not yet washed out. Consider the very simple chart above, which measures the short term readings of all S&P 500 stocks above the 20 day moving average. Currently, there are still 43% of components above this short term MA and for the market to turn oversold, we usually need to see readings drop below 10% or 2 standard deviations from the mean of 56%. Verdict: in my opinion we are not there yet.
        Source: Short Side Of Long

        Another short term breadth measure is an a very basic indicator I created called Weekly Internals. It tracks cumulative weekly readings of the NYSE advancers minus decliners and up volume minus down volume. In other words, it is the smoothed weekly buying and selling pressure. The capitulation zone usually occurs when 70% or more of all stocks and their volumes move on the downside during the week. Currently sitting in a neutral zone, we are not anywhere close to oversold readings. Verdict: in my opinion we are not there yet.
        Source: StockCharts / Short Side Of Long

        Other short term breadth measures I usually track are shown in the chart above. They are the percentage of stocks above 50 day MA, McClellan Oscillator and daily TRIN readings. All three indicators have a basic oversold level and all three indicators are not signalling oversold conditions. Verdict: in my opinion we are not there yet.
        Source: Short Side Of Long

        Longer term breadth measures also show the same picture. The long term advance decline line, averaged over 21 days or one month of trading, shows that we are currently at neutral readings and nowhere near oversold levels. Verdict: in my opinion we are not there yet.
        Source: Short Side Of Long

        The percentage of stocks above the longer term 200 day moving average is also nowhere near oversold levels. As a matter of fact, the smoothed 21 day average of the readings above, shows that the breadth strength is now rolling over and starting to narrow. Furthermore, we can see that a bearish divergence between lower breadth readings and higher stock prices into September 2012. All of these are usually typical signs of a downtrend at its beginning and not at its end. Verdict: in my opinion we are not there yet.
        Source: Short Side Of Long

        Moving along, we can also see that the NYSE 52 week high low ratio, averaged over 21 days or one trading month, shows that readings have just exited overbought territory. That itself signalled an intermediate top and a correction in progress. When does that correction end? During bull markets, correction readings fall below 50%, but if I am right in forecasting a bear market, readings might go much lower towards the true oversold zone of 10%. Verdict: in my opinion we are not there yet.
        Source: Cobra Market View

        Moving away from breadth and towards basic technical price action, we can see in the chart above that we have a classic non confirmation in the Dow Theory. These usually get resolved to the downside, especially when stocks remain in a long term secular bear market. Verdict: in my opinion we are not there yet.
        Source: StockCharts / Short Side Of Long

        I am definitely not an expert in technical analysis and momentum readings, and I rather not be because charts have very lousy prediction probabilities unless you incorporate them together with the fundamentals of the business cycle as well as sentiment readings. Having said that, just looking at the weekly basics, I see no minor or major oversold readings right now. As a matter of fact it seems to me that the weekly MACD is now giving us a selling signal instead. Verdict: in my opinion we are not there yet.
        Source: Short Side Of Long

        Finally, away from the stock market indicators, the bond market readings of future inflation expectations, also known as Break Even rates, have been overheating for a few weeks now. That tells us the current inflation trade is looking somewhat overcooked and mainly a consensus bet. Historically, a deflation trade (long Treasuries, Dollar, Yen, VIX) surprise tends to be just around the corner, as market participants start cutting risk exposure rather quickly. Furthermore, I personally think the Fed engaged into QE3 prematurely, instead of waiting for Break Even rates to fall back down to 2% range. This has now most likely topped the risk on trade, just like we saw in April 2010, November 2010 and between February & May of 2011. Verdict: in my opinion we are not there yet.

        Trading Diary (Last update 25th of October 12)
        • Long Positioning: Long focus is towards the secular commodity bull market, with positions in Precious Metals (weighted heavily towards Silver) and Agriculture. A small individual position in Sugar was recently added. Underlying position as well as call options are held on Japanese Yen (long dated OTM).
        • Short Positioning: Short focus is towards the secular equity bear market, with positions in Dow Transports, Technology, Discretionary, Industrials and Junk Bonds. Put options are held on Apple, Amazon and recently Salesforce (long dated OTM). Put options are held on Pound and Loonie (long dated OTM).
        • Watch-list: A major short in due time will be US Treasury long bonds, as they are extremely overbought and in the midst of a huge bubble. While Grains have exploded, Softs present amazing value for investors. Japanese equities are down about 80% from their all time high over two decades ago and offer great value.
        What I Am Watching