Are Bulls Getting Ahead of Themselves?
Note: This story was originally published on Standard & Poor's MarketScope on Oct. 11, 2007.
A funny thing happened on the S&P 500's way to 1600. Market sentiment has quickly started to exude confidence, and while these measures of emotion many times precede intermediate-term tops by a month or two, it is certainly not a good time to relax and get too complacent.
We have previously written that we thought that the stock market might have the wind at its sails into January, 2008, due to the strong seasonal effect that many times runs during November, December, and January. During bull markets since 1970, it has been rare to see intermediate-term declines that start in November or December because of the positive seasonal bias. This has now been put into question, as enough of our sentiment indicators have moved quickly to the bullish camp, and these indicators have many times led intermediate-term peaks by four to eight weeks, which puts us into the middle of November to the middle of December.
One potential which would satisfy both sentiment and seasonal forces, in our view, would be a strong move into mid-November/mid-December, followed by a market that slowly grinds higher into January, but makes little progress. We have seen this type of intermediate-term top in both 2006 and 2007.
We still believe that the market has more upside and think the "500" has a good shot of reaching the 1600 to 1650 area before the end of the year. We are just unclear about when the forecasted top will be. Price volatility has plummeted over the last 3 weeks and the S&P 500 has been in a very consistent uptrend over that time. In our view, we are in the sweet spot of an intermediate-term uptrend. The timing of a top has a lot to do with the velocity of price.
No, we are not going to give a physics lesson. If we get an upside blowoff, we think the intermediate-term top could come fairly quickly, and this would take the market farther than we are expecting. If the market advances in a nice consistent manner, and the slope of the rise does not become too steep, then we think the timing could extend into the latter parts of 2007 or into early 2008.
Another thing to watch for if we are approaching a peak in prices is a pickup in volatility. Many times as the market is topping, institutional distribution becomes more prevalent and this shows up in higher price volatility as supply catches up with demand, and you get a real tug of war between buyers and sellers.
So where have all the bulls come from? Or just as curious, why did we all of the sudden see a pickup in speculation and bullish sentiment? While we may not know the answers, we surmise that it had a lot to do with the aggressive moves by the Federal Reserve, and the very positive price action of the global stock markets. Quite frankly, we don't really care where the bulls are coming from or why sentiment jumped recently, but we care more that it has happened and how it affects our stock market outlook.
One of the most accurate sentiment/speculative gauges we monitor is the ratio of Nasdaq volume to NYSE volume. The idea of this indicator is too measure when speculation is high or low. When Nasdaq volume rises in relation to NYSE volume, we believe this is a good indication that speculation is rising as the higher beta issues generally reside on the Nasdaq, and the stodgy blue chips are more likely to trade on the NYSE.
One of the ways to see if speculation is rising is to look at the 3-week average of Nasdaq volume to NYSE volume. Over the last four years, this ratio has tended to oscillate between 110% and 140%. We designate extreme readings above and below this range. The current reading as of the end of last week was 152%. Not counting the present reading, we have seen this ratio rise to 140% or above on five occasions since the beginning of 2004. Each time preceded an intermediate-term top by four to eight weeks. Observing this data on a daily basis gives us a similar predicament. When the ratio has risen to 150% or above on a daily basis, it represented a good warning sign that a top was approaching.
We are excluding high readings when they occur very near an intermediate-term bottom and only looking for high levels of speculation when the market has gotten extended. As of Wednesday, we have seen six straight readings above 149% with a high of 177% on October 8. This was the highest and most speculative condition since March 2004.
The ISE Sentiment Index is also starting to exhibit an uncomfortable level of speculation, and like the above mentioned indicator, it has been an early warning of many intermediate-term summits. This index is a measure of investor sentiment calculated by comparing the number of opening long call options to opening long put options on the International Stock Exchange. The measure only considers the purchases of customers and does not include the purchases made by market makers, as customers are thought to be the best measures of sentiment. The index hit 187 on October 8, exceeding the levels hit in July 2007, just prior to the market rolling over. The 21-day ISE index is up above 140, not far from the peaks in July 2007 and December 2006. Many times, the market does not peak until the ISE sentiment index peaks and starts to head lower.
Put/call (p/c) ratios have fallen quite rapidly of late and are at or near levels that have preceded market tops. The 10-day total CBOE p/c ratio is down to 0.87 after peaking at 1.29 in mid-August. We view an extreme on the 10-day p/c ratio to be below 0.85, so we are very close. However, these ratios can get oversold and stay low for many months before prices peak out. Many times, market tops occur when these ratios bottom out and then start to head higher, as the trend of placing bullish bets changes and investors start to take more bearish bets.
Investor's Intelligence poll is showing 60.2% bulls and only 21.5% bears. This is the highest percentage of bulls since December 2005 and the lowest percentage of bears since July 2007. When we have seen a dramatic disparity in this poll among the bulls and the bears over the last four years, the market was able to continue higher but gains were for the most part, already behind you.
While we think the trend is still higher, and we see additional gains as we move further into the fourth quarter, we think price volatility is going to increase, as price gains will become tougher and tougher to achieve. We believe risk is rising, but think it is too early to abandon ship.