Vast majority of traders now bearish, equities short-term oversold

The easy money for the shorts has been made. This doesn’t mean that the market is likely to rally, just that we have now enjoyed the portion of the decline that our intermediate-term sell signal in late September and early October all but guaranteed. This in no way rules out further declines immediately ahead, possibly severe. It is just that traders could easily find safer entry points for short-to-intermediate-term short sales, or worse exits.

Stocks remain at historically high valuations, economic headwinds are mounting, and bullish sentiment has been dominant for years, so we are likely at the start of a significant turn.

yahoo SPX 1 year

Technical update: overbought, overbullish, declining RSI

We finally have the classic syndrome that indicates an intermediate-term top. Upward momentum has stalled, as sentiment has remained elevated for several weeks. The combination of sideways prices on high bullish readings becomes very bearish when it has been sustained for a month or longer.

Here is the RSI and price picture (note declining trend in the momemtum indicator RSI since late August, and its resemblance to the topping pattern last spring):


Charts from Yahoo

A quick glance at sentiment shows sustained optimism:

Looking at the headlines, it is nice to see good news that results in a bump with no follow-through. We saw that in mid-September with QE Infinity, and last Friday with the jobs report. Rallies end on good news and declines end on bad news.

It would not be unusual to see another test of the highs, and for prices to linger at these elevated levels for another month or so, but the odds of a sharp decline are now elevated, and any further gains should be quickly erased.

Market again overbought on overbullish sentiment

The global economy is clearly on the downswing, with the US likely having entered a recession this summer (watch for revisions in GDP and employment data in the coming months). However, as in Sept-Oct 2007, the equity market has bounced from a brief oversold interlude to a new high.

Here is the NAAIM survey. This is a relatively new dataset, but it has proved high-correlated with proven sentiment indicators like DSI and Rydex fund activity). The survey is updated each Thursday with data from Wednesday.

NAAIM Sentiment Survey, 19 Sept 2012

Sentiment has been elevated for a month, which is sufficient for a significant decline, though the likelihood of a setback and the expected magnitude thereof grows with each week that it remains elevated. This, coupled with sideways price action for few weeks (we don’t have this yet) and a declining trend in daily RSI (possibly developing) would virtually lock in the case for an intermediate-term top.

S&P500 daily chart, Yahoo Finance

EDIT: To clarify, this is not a screaming short-term sell yet, since the market has had a habit of creaping slightly higher over a few weeks from conditions like this. However, things can reverse at any time, and it is highly likely that any further gains will be quickly erased once the turn comes.

The macro picture of deteriorating economic data bolsters the case that a bull market top is near, so if this is an intermediate-term top it could prove to be the final top prior to a bear market. This cyclical bull is now 3.5 years old. This is long in comparison to the cyclical bulls of the 1910s and 1970s secular bear markets (18-36 months was typical), but short in comparison to the last cyclical bull (spring 2003 – fall 2007, 4.5 years).

Where are we in the secular (post-2000) bear?

Mish Shedlock’s investment management company, Sitka Pacific, provided this chart in their September letter (as a non-client, I only get delayed copies):


One lesson to be learned here, which they get into in the letter, is that prices bottom before valuation multiples. In the bears of the 1910s, ’29-early 40s and ’66-82, inflation appeared late in the game. BTW, this meshes with Kondratieff theory, where inflation leads to disinflation to deflation then inflation again, with asset values moving in tandem.

So, be prepared to buy in this coming wave down, if we get a nice drop over the next year or so, because select equities could be a nice hard asset to own through the turmoil in the currency and sovereign debt markets, which is likely to spread to the US, UK, Germany and Japan by later this decade.

Hussman: recession imminent

This is from his always worthwhile weekly Market Comment (this week he makes an airtight case against taking market risk at this time, with a recession all but guaranteed and no cushion of safety or reasonable expectation of a decent return in stocks or bonds).

I liked his comment about how although his fund has been very conservative and fully-hedged for most of the last several years, this is more a reflection of unfavorable market conditions than some sort of permabear tendency:

The overvaluation, misguided policy, and misallocation of capital that has produced more than a decade of dismal returns for the S&P 500 has also forced us to take a regularly hedged investment stance in response (though we know that the ensemble methods presently in use would have done things differently in several periods, particularly 2009 and early 2010). While our investment approach is by construction risk-managed, it is not by construction hard-defensive or fully-hedged. These are positions that have been thrust on us by conditions that have, predictably, led to a decade of stock market returns far below the historical norm. Though the present menu of prospective investment returns remains unappealing, those conditions can change quickly, particularly in a crisis-prone environment. This is important to mention here, because I strongly expect that we will begin seeing opportunities – probably not immediately but also not in the distant future – to significantly and perhaps sustainably reduce the extent of our hedging.

We emphatically don’t need to wait for the world to solve its problems before being willing to accept risk. What we do need is for those risks to be more appropriately priced in view of those problems. We’re not there by any means, but a significant change in the market’s return/risk profile could come quickly. To quote MIT economist Rudiger Dornbusch (who was a professor to the new head of the ECB, Mario Draghi), “The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.”

See this part on how his never-failing set of recession indicators is again flashing red:

Reduce Risk

Here in the U.S., our broadest models (both ensembles and probit models) continue to imply a probability of oncoming recession near 100%. It’s important to recognize, though, that there is such a uniformity of recession warnings here (in ECRI head Lakshman Achuthan’s words, a “contagion”) that even an unsophisticated, unweighted average of evidence indicates a very high likelihood of recession. The following chart presents an unweighted average of 20 binary (1/0) recession flags we follow (e.g. credit spreads widening versus 6 months earlier, S&P 500 lower than 6 months earlier, PMI below 54, ECRI weekly leading index below -5, consumer confidence more than 20 points below its 12-month average, etc, etc). The black brackets represent official recessions. The simple fact is that we’ve never seen a plurality (>50%) of these measures unfavorable except during or immediately prior to U.S. recessions. Maybe this time is different? We hope so, but we certainly wouldn’t invest on that hope.

Rumors of dollar’s death greatly exaggerated

Sentiment is still very anti-dollar (though not as extreme as last February-April), but the index is no lower than a few months ago, nor even a few years ago. Despite all of the dollar-crash and hyperinflation hysteria in recent years, early 2008 still marks the bottom.

MACD and RSI also seem to back up the case that the next big move is more likely up than down:

3 year daily chart:

5-year weekly chart:

10-year monthly:

The 10-year chart says it all: the dollar has already crashed, and as is typical in the financial markets, few noticed or attempted to take action until the move was already over.

VIX & Put:Call starting to make puts attractive again

A fair degree of complacency has snuck back into markets over the last month.  We don’t have a strong sell signal in stocks yet, but if April marked the high in US and European markets and economic indicators are turning down again, this could be a good spot to start building short positions again:


Here’s the equity put:call vs the 20 day moving average, back to one standard deviation under its mean. Dipping lower would require the kind of extreme complacency that we’ve only seen twice in the last decade, so I wouldn’t count on it:


The dollar has also corrected its overbought condition (and is actually very oversold), which is key for a resumption of the deflation trade:

John Hussman agrees May 6 decline no glitch, but normal and even predictable

Summary: Crashes are a normal consequence of extremely overbought and overpriced markets, and huge rallies like Monday’s are almost the exclusive providence of bear markets. Crashes and giant rallies are both characteristic of times of credit stress.

First, let John Stewart explain (if like me you’re not in the US, try this trick to watch restricted videos) :

The Daily Show With Jon Stewart Mon – Thurs 11p / 10c
A Nightmare on Wall Street
Daily Show Full Episodes Political Humor Tea Party


Now on to Hussman. The below is taken from his latest market comment. You could also say that Hussman “called” this decline, since starting several weeks prior to the peak (see archive) he characterized the market as “overvalued, overbought, and overbullish” and hedged up his stock mutual fund with put options and short call positions. I have followed him for some time, and he is as good a market timer as I know*; you don’t want to be long stocks when he’s fully hedged!

Of all the mysteries of the stock exchange there is none so impenetrable as why there should be a buyer for everyone who seeks to sell. October 24, 1929 showed that what is mysterious is not inevitable. Often there were no buyers, and only after wide vertical declines could anyone be induced to bid … Repeatedly and in many issues there was a plethora of selling orders and no buyers at all. The stock of White Sewing Machine Company, which had reached a high of 48 in the months preceding, had closed at 11 on the night before. During the day someone had the happy idea of entering a bid for a block of stock at a dollar a share. In the absence of any other bid he got it.”

John Kenneth Galbraith, 1955, The Great Crash

“I started accumulating stocks in December of ’74 and January of ’75. One stock that I wanted to buy was General Cinema, which was selling at a low of 10. On a whim I told my broker to put in an order for 500 GCN at 5. My broker said, ‘Look, Dick, the price is 10, you’re putting in a crazy bid.’ I said ‘Try it.’ Evidently, some frightened investor put in an order to ‘sell GCN at the market’ and my bid was the only bid. I got the stock at 5.”

Richard Russell, 1999, Dow Theory Letters

…If the decline we’ve seen to date is the entire resolution of the recent overvalued, overbought, overbullish, rising-yields syndrome, investors will be fortunate. Given that last week’s decline was just enough to clear the “overbought” component of this condition at least on short-term basis, we lowered our S&P 500 put strikes closer to current market levels and “re-set” our staggered strike hedge in the Strategic Growth Fund enough to put us in a more constructive position if the market advances more than a few percent, while maintaining a strong defense against a further market loss. Our overall position is much like a fully hedged stance with a couple of percent of assets in out-of-the-money index calls. We’re in no hurry to “buy the dip.” We don’t rule out much larger, and possibly profoundly larger market losses, but again, last week gave us a nice opportunity to re-set our strikes in a way that allows us to be comfortable in the event that the market recovers.

Thursday was a fascinating day in the market, featuring a 20-minute span in which the Dow moved from a loss of about 300 points to a loss of nearly 1000 points and then back again within a span of about 15-20 minutes. While the decline and recovery was interesting, the fascinating part was the eagerness of investors to view the decline as a “glitch” in trading. My hope is that the opening quotations in this weekly comment are sufficient reminders that illiquidity is not a “glitch,” but a typical feature of panicked markets. In a market where active market makers have increasingly been replaced by “high frequency” trading algorithms that can be switched off at will, it is important for investors to avoid the assumption that there will be a willing buyer close at hand if risk concerns begin to escalate.

If you spend a good portion of your time studying price-volume behavior, “air pockets” of the type we observed last week become familiar parts of the landscape (though they are typically not so distilled into a single intra-day move). Robust demand is the only thing that holds prices from falling vertically in the face of eager selling. Overvalued, overbought, overbullish markets are often already spent of that demand. As investors suddenly became aware of that reality on Thursday, all I could think was “welcome to my world.”

…I think the best way to characterize the market here is to view the area between 1080 and about 1130 on the S&P 500 as something of an “inflection point.” A clear decline below about 1080 on the S&P 500 would most likely put market internals in a clearly negative position, leaving the market with a coupling of overvaluation and negative market internals that has historically been very hostile. We’re not yet to that point, however, so it’s reasonable to allow for the potential for a recovery from these levels while still maintaining a tight hedge against further weakness.

I made many of the same points prior to the mini-crash (, noting the likely record extreme in bullish complacency in the equity put:call ratio, as well as extreme overvaluation and mutual fund cash levels matching the 2007 peak.

After the crash last Thursday I noted that these things just happen. They are one of the risks of the stock market, and are as old as floor trading:

The fact is, markets just fall out of bed sometimes. It’s normal, and they don’t need the kind of reasons you can read about in the paper. Greece had nothing to do with it.

A move like this off a top does not mark the end. If we had plunged hard and reversed like this after we were already reading oversold on sentiment and momentum gauges, it could mark a bottom, but not right off the top — that is what should scare people today. This was not like Black Monday ‘87 — it’s more like the Black Thursdays of ‘29 and ‘08 (huge intraday crashes with recoveries, followed the next week by the real crashes), or the Friday before the ‘87 crash (down 5%). It’s likely a kickoff to more downside. New highs are possible, but looking less and less likely, and we doomsayers might be right after all these months…

You can’t predict a crash, but you can tell probabilities, and the probability of a decline was high as of last week. We had an extremely, extremely depressed put:call ratiomomentum was rolling over, mutual funds were all-in, and just about every measure of sentiment showed that complacency and bullishness were off the charts.

Also the day after the crash I said not to blame the computers and not to reverse those trades:

I didn’t mention anything about computers here, which any discussion of yesterday should have. So yes, computer stop-loss orders kicked in and buy orders were pulled, but this is just what would happen with humans. Every market in the world has experienced some kind of crash this week. It’s not the machines – they basically just do what people do, but faster.

However, you can probably blame computers if you got screwed out of something during a split-second 50-99% drop — that would probably be less likely to happen in a market with human specialists to absorb order flow with their brokerage’s books.  But that’s not the cause of the crash, just something that happens during a crash — buyers pull out and stop-losses kick in. In ‘29 you also had solid companies selling for a buck for a few trades. That’s just the way the cookie crumbles, and one of the myriad risks of the equity market.

(BTW, breaking those trades was likely a bad decision on the part of the exchanges. If they had let them sit, those kinds of ridiculous plunges to a penny would be less likely to happen again, as everyone today would be coding away to program their bots to snap up “bargains” during the next swoon. If they could just turn around and cancel the trades, who’s going to take that risk, since you might end up short a stock trading at $20 the next day that you’d bought for $10 and sold for $15?  Doesn’t anyone believe in markets anymore? Not even people who run the stock markets? Just let them be, and participants will naturally seize opportunities and add efficiency to the market.)

The cause of this crash is just an overbought, overbullish, overvalued market during a depression (9.9% headline unemployment again, 17% real).


Mish provided these charts (visit his post to see more data) which help to put the drop into perspective (“largest point drop in history” is meaningless — what counts is the percentage). The data here also shows that huge single-day rallies like Monday’s seem to only happen in bear markets, (as I pointed out on Day 2 of this blog back in August 2008 before the crash):

*By the way, here’s the 10-year record of Hussman’s equity mutual fund (top blue line), which, as I understand it, is contractually obligated to be near fully invested in stocks at all times, though it may hedge 100% of its long exposure but not go net short: