Short Takes

The exception to the sentiment rule can come at the early stages of a strong trend; so the data below should be reviewed in that light. However, sentiment appears to be aligning in a bearish fashion with other technical indicators. The text below was written by the man who literally wrote the book on technical analysis - Robert W. Colby, author of The Encyclopedia of Technical Market Indicators (www.RobertWColby.com).

The latest Commitment of Traders (COT) report shows that the Commercials (giant corporations with deep pockets) have been buying “risk off” defensive futures contracts, specifically, the U.S. dollar and the ten-year Treasury note. On the other side, trend-following Speculators have been buying “risk on” aggressively bullish contracts, setting a new all-time net-long record in the Nasdaq futures. The unusually large size of Speculators’ positions implies a weak-handed, top-heavy stock market.

AAII Sentiment: There were 43% Bulls and 27% Bears, according to the AAII weekly survey reported on 2/16/12. Net bullish opinion is as high as it was last July, near the market top.

Investors Intelligence Sentiment: There were 54.8% Bulls versus 25.8% Bears, according to the Investors Intelligence weekly survey of stock market newsletter advisors reported on 2/15/11. This is the highest level of bullish sentiment since the stock market top in May, 2011.

Investment Newsletters are 75% bullish, the highest since near the major top in year 2000, according to Hulbert Digest.

Market Vane’s Bullish Consensus among Advisors and Newsletters rose to 66% Bulls this month, in the same 64% to 69% range of Bulls from February to July 2011 at the highs.

Short Selling ETFs are trading the lowest volume since the market top in April, 2011, according to Frank D. Gretz of Wellington Shields & Co.

Corporate insiders have been selling their companies’ stock at the heaviest rate since the market peak last July, according to Mark Hulbert at MarketWatch. Insiders sold 577 shares for each 100 shares they bought, according to Argus Research Vickers Weekly Insider Report. That is a big change in insider behavior from 81 shares sold for each 100 shares bought in November. Since corporate insiders (officers, directors, and largest shareholders) know so much more about their companies than the public can possibly know, it is bearish when insiders sell at such a heavy pace.

NYSE short interest collapsed from a high peak of 16.1 billion shares sold short last September, which coincided with the stock market lows, to 12.5 billion shares sold short in February. This is the lowest level since last April, at the market top. Short interest represents a pool of potential demand for stocks, since short sellers eventually must buy back the shares they borrowed. Currently, that pool of demand is depleted.

VIX Fear Index broke down below the lows of the previous 6 months on 2/3/12, hitting 16.10 intraday. That was down from a peak of 48.00 on 8/8/11. Such a large drop in VIX indicated a shift away from fear and toward bullish complacency, which may be bearish. VIX is a market estimate of expected constant 30-day volatility, calculated by weighting S&P 500 Index CBOE option bid/ask quotes spanning a wide range of strike prices for the two nearest expiration dates.

Upon Further Review: After looking more closely at a few of the historical ADX cases for the NASDAQ, we noticed something “not so bullish” about the NASDAQ’s current ADX line. The text below is from the book Trading For A Living:

When ADX (black line) rallies above both directional lines (red & green), it identifies an overheated market. When ADX turns down from above both Directional lines (red & green), it shows the major trend has stumbled. It is a good time to take profits or partial profits.

As you can see below ADX black is above green and red, which meets the criteria for an overheated market.

When the ADX black line (shown below) is at low levels, it is indicative of a trendless or sleepy market. When the line begins to rise it shows a strengthening trend (up or down). A move from low levels to 51.55 is very rare. We closed at 51.55 on Friday as shown on the current chart below.

Therefore, if ADX black turns down, it probably means we are close to a pullback of some kind.

In the last 31 years, we found only 12 cases where ADX hit 51.55 during the relatively early stages of a new uptrend. In only 2 of the 12 cases was the ADX black line above both the red and green lines. In both cases a short, but sharp, correction of roughly 4% was followed by more gains. A sharper correction materialized within a few months.

Between roughly 3:30 p.m. on Tuesday and now, we have seen a 20 point swing in the S&P 500 futures. The market has reacted to stories about:

1. Word that leaders in Greece will provide assurances to refrain from making changes to the next bailout over the coming months (nothing in writing yet).
2. China will support the bailout efforts in Europe.
3. Europe may delay Greece’s 2nd bailout while exploring ways to avoid default.

Given the extended nature of the markets and current DeMark counts, the odds of a reversal remain elevated as long as the S&P 500 fails to close above 1,364.01, based on the 9-13 Sequential count. DeMark indicators are proprietary tools developed by Tom DeMark of Market Studies, LLC. The daily Combo count still allows for three closes above 1,352. The Combo count in the S&P 500 E-Mini futures also allows for two more closes greater than 1,349. We are looking at gold and gold stocks on the long side (emphasis on looking).

Friday’s pullback could have been much worse when you consider the news of the day and the extended nature of the markets. The fact that stocks held up relatively well is a sign of strength. If markets are able to hold onto early gains Monday, we may make some adjustments to become better aligned with the bullish bias.

We could still see a correction relatively soon, but we would like to see something to support that in the next day or two (weak volume, weak breadth, can’t hold gains into Monday’s close, etc.). The U.S. dollar is holding up relatively well Monday morning and gold is having trouble holding onto early gains; both lend some credibility to the pullback case.

Heading into Monday’s trade, the CCM Bull Market Sustainability Index (BMSI) currently points to a very favorable risk-reward outlook over the next two to twelve months.

The bullish outlook is also supported by the CCM 80-20 Correction Index. The historical risk-reward ratio for markets with similar profiles was very favorable in the subsequent three to twelve months.

How could the markets go from the edge of a cliff in mid-December 2011 to the bullish stance we have today? The answer is money printing and a “free lunch” for banks. From Bloomberg:

The ECB is flooding the banking system with cheap money in a bid to avert a credit crunch after the market for unsecured bank debt seized up last year and funding from U.S. money markets disappeared. Any bank in the region can borrow an unlimited amount, provided it pledges eligible collateral. Lenders won’t face curbs on bonuses or dividends.

Lenders could take 680 billion euros of loans at the second auction on Feb. 29, according to a Goldman Sachs Group Inc. survey of investors published last week. That would raise total borrowings from the ECB’s longer-term refinancing operation, or LTRO, to a record 1.2 trillion euros, surpassing the $1.2 trillion in peak lending by the Federal Reserve to U.S. banks after Lehman Brothers Holdings Inc.’s 2008 collapse.

This is very much a free lunch,” said Arnd Schaefer, an economist at WestLB AG in Dusseldorf, Germany. “Banks can get money for just 1 percent and then lend it on for much more.”

The ECB’s three-year loan facility is a form of back-door quantitative easing (QE). Our series of QE videos from late 2010 explain why QE/money printing can boost asset prices. The ECB’s next round of unlimited three-year loans to banks takes place on February 29, 2012, meaning the market will be reacting to another liquidity injection over the coming weeks.

The bears still have conditions in place to kick-off a correction, but thus far they have done little damage to the bullish case. If a correction takes place, we would view it as a QE-induced buying opportunity.

We thought the German DAX could hit 6,837; today’s high was 6,830. While the DAX could spike higher in the coming days, the odds are good those gains would be retraced relatively quickly. We will see how things play out over the next week or so and adjust accordingly. The German ETF (EWG) has a high correlation to the DAX. Our target for EWG was 22.63; today’s high, as of 2:00 p.m., was 22.67.

We will be watching our position in Germany (EWG) closely over the next few days. The chart below shows the German DAX’s performance relative to the S&P 500. Note when RSI (top) reaches levels similar to what we have seen recently (blue arrows), the DAX’s relative performance tends to weaken (center of chart). The black ADX line (bottom) shows the strength of the current trend. The ADX line is trying to roll over now, which is indicative of a weakening trend. The orange arrows highlight the current and historical ADX black rollovers that occurred near peak RSI levels.

On the DeMark chart of Germany (EWG) relative to the S&P 500 (SPY), we are nearing an exhaustion count. In recent history, similar DeMark signals were followed by a pullback in risk assets (red arrows). These signals can be a little early (late 2011 below), which means stocks and commodities may have some more upside.

We are working on client game plans; comments will be brief. Yesterday’s close above 1,325 put the daily DeMark combo count into a fragile state. There is some hope for it being a good signal if we remain below 1,331.91 on a closing basis. The outcome could be bullish since “bad signals tend to be really bad”, which is reflective of a strong market. Odds are good we will make some moves today, especially with a close above 1,331.91.

Other factors: German bonds weak, U.S. dollar weak, euro strong, Italian yields falling, European stocks firming.

Good news for the exhaustion/reversal case: S&P 500 made a high today that will most likely trigger another monthly DeMark exhaustion signal for the S&P 500; we would need to finish the month above 1,277, which was the November 2011 high. Monthly signals have a good track record; something we will respect.

Bad news for the exhaustion/reversal case: Three “stop-loss” or DeMark risk levels were violated in recent days: (a) 1,324 on a weekly chart, (b) 1,312 on a daily, and (c) 1,325 on a daily. As we noted last night, if the signals are “wrong”, they tend to be “really wrong”, meaning stocks could march higher in a rapid manner. Another close above 1,324/1,325 may prompt us to consider making some changes. We will prepare for more upside as well as more downside.

The Fed opened the door to more “easing” and “accommodative policy” through late 2014, which means they will continue to flood the financial system with printed money and they will continue to grow their balance sheet; both of which tend to be friendly for asset prices.

Relative to potentially bearish DeMark trend exhaustion signals, the most important S&P 500 level is 1,344. All things being equal, we would prefer to see the S&P 500 remain below 1,343. Similar, but less important levels include 1,326 and 1,313. Several conditions have to be met for a “violation” - it is more than just a close above. For example, the 1,313 level has not been negated yet (three more things need to happen).

Markets can peak on good news - remember when the “breakthrough” euro summit sparked a big rally? It marked an intermediate top. Therefore, an Apple and Fed-induced spike that remains below 1,344, then reverses intraday would be best case scenario for trend exhaustion. It is important to keep in mind if the signals are “wrong”, they tend to be “really wrong”, meaning stocks could march higher in a rapid manner. Thus, the need for an open mind and flexibility.

Market breadth (think advancing stocks vs. declining stocks) has been weakening in recent weeks, which is indicative of a tired market. The Summation Index, an intermediate-term measure of market breadth, closed below 100 on Thursday. In the chart below, the blue vertical lines show drops below 100 during the last five years. In the present market, point A1 is similar to point A and point B2 is similar to point B. The orange arrows show that “snap back” rallies can occur after a drop below 100, but with weak breadth the rallies tend to fail. The S&P 500 is shown at the bottom of the chart.

The current rally may turn out to be similar to the rally in July (see point A below). The green arrows near point A and A1 show momentum for an initial push higher. The orange arrows show a fairly tame move lower. The pink arrow below point A shows a very weak push higher that eventually failed. The Accumulation/Distribution line (bottom of chart) allows us to track the volume backing market moves, which is an indirect way of monitoring what big buyers are doing. Institutions (big buyers) did not support the July rally (see point B), which is similar to the present day (B2).

While it is far from a textbook pattern, the S&P 500 has traced out a “head-and-shoulders like” pattern (see S H S in chart above). The concept of the pattern still applies; the market is skeptical of the first push higher during the formation of the left shoulder, but there is enough interest to push stocks higher. When the head is formed more buyers have shifted to a bullish stance allowing for a higher high. The right shoulder is small relative to the left shoulder and price makes a lower high, which is indicative of waning interest from buyers. A head-and-shoulders pattern tends to be bearish. As noted yesterday, today is an expiration day, which slants the bias toward the bulls.