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SENTIMENT JOURNAL: Bear Barometer Still Rising
Friday March 16, 7:30 pm ET
By Frederic Ruffy
Market Internals: Stocks moved higher during three of five trading sessions in the latest week of trading, but thanks to a severe sell-off on Tuesday, are poised to finish below week ago levels. Through midday Friday, the Dow Jones Industrial Average (^DJI) had given up 155 points. The NASDAQ was down approximately 13 points on the week.
However, while the major average lost ground, the tale of the tape was not entirely bearish. For one, the high volume day occurred on Wednesday, when the Dow rose 57 points and up volume on the New York Stock Exchange [NYSE] outpaced down volume by a margin of more than two-to-one. In addition, the NYSE New High New Low Index did improve. It fell into negative territory (-5) following Tuesday's sell-off, but bounced back to +39 on Thursday (with 69 stocks setting new 52-week highs and 18 falling to new lows.) Meanwhile, market breadth has been mostly positive. To be specific, advancing issues have outpaced declining issues on the NYSE during six of the past seven trading sessions and during five of the past seven trading sessions on the NASDAQ (See table above for details.)
Sentiment Indicators: While the technical action of the market seems to be improving somewhat, levels of bearishness and market angst remain elevated. For example, midday Friday, the CBOE Volatility Index (^VIX) was up .71 to 17.14. The market's "fear gauge" seems to have found a new trading range, which is significantly higher from the average of 12.80 seen throughout the year 2006.
Meanwhile, the International Securities Exchange Sentiment Index [ISEE] seems to have found a new range as well. The ISEE is an indicator that is computed using options activity on the International Securities Exchange [ISE], which is the largest exchange for the trading of puts and calls. The index is computed as the day's call purchases divided by put purchases, multiplied by 100. For example, if one million calls traded on Wednesday and 500,000 puts, the ISEE will read 200. During previous market tops, when investors have clearly become overzealous or irrationally exuberant, the ISEE would often rise above 200 during several consecutive trading sessions. In short, high readings are a sign of heavy call buying and excessive bullish sentiment.
However, recently, the International Securities Exchange Sentiment Index has been producing a series of extremely low readings. It has failed to rise above 100 during eight of the past ten trading sessions. Figure 1 shows the ten-day average of the indicator. On Thursday, it fell to 87 and a new record low. It is clearly below the level seen when the stock market staged its last significant bottom in the summer of 2006. The new lows in the ISEE are sign that bearishness and pessimism have reached extremes and, from a contrary view of the markets, the extreme sentiment is reason to be bullish!
Figure 1: ISEE Ten-Day Average
There is an old adage among traders that goes, "the crowd is generally right on the trend, but wrong at both ends." To identify the "ends", contrary-minded thinkers tune into market sentiment and try to determine if bullishness or bearishness among the "crowd" has reached an extreme. If it has, the table might be set for a reversal. In today's setting, there are indeed convincing signs that bearish sentiment has reached an extreme and therefore the table might be sent for a market bottom.
However, as Humphrey Neil warns in his book The Art of Contrary Thinking, the contrarian always runs the risk of being too early. For that reason, although many indicators suggest that bearish sentiment has become extreme enough to form the basis for a genuine market bottom, it might be early to venture in with aggressive buy orders. Instead, it might make more sense to wait for the technical action (discussed in the opening paragraphs) to show more improvement because experiences also teaches us that, it's often the second mouse that gets the cheese.
Frederic Ruffy
Senior Writer & Index Strategist
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