A Conversation With Bernie Schaeffer
By Lawrence Carrel
SmartMoney.com
Thursday January 9, 4:53 pm ET
BERNIE SCHAEFFER BEGAN his career as an insurance actuary, trying to determine the life spans of people with various physical characteristics. After a few years, he decided that determining the life span of bull and bear markets would be a much more exciting — not to mention more lucrative — vocation. In 1981, he founded Schaeffer's Investment Research and began writing Bernie Schaeffer's Option Advisor, which has become one of the leading newsletters in the arcane but fascinating world of equity options. He has written numerous books about investing, and his Web site, SchaeffersResearch.com, provides daily market commentary.
Schaeffer is perhaps best known as a prescient market timer. Last week, he was named top forecaster out a field of 50 in BusinessWeek's 2002 Market Forecast. Timer Digest, a financial publication that tracks 100 timing models and investment newsletters, ranks Schaeffer the No. 1 timer on the Standard & Poor's 500 for the three-year period ending Dec. 31, 2001, and the No. 1 gold timer for the 10-year period ending Dec. 31, 2001.
First and foremost a technical analyst, Shaeffer uses the options market as his guide. He began turning bearish on the Nasdaq in autumn 2000 and on the S&P 500 in February 2001. We asked him what methodology he uses, and what path he expects the market to take in 2003.
SmartMoney.com: What gauges do you use to time the market?
Bernie Schaeffer: We look at the S&P 500, the Nasdaq and the Dow Jones Industrial Average. First we look at long-term moving market averages — 10 months, 20 months, even 80 months — and from that bigger-picture perspective, we then look at the market's current trend. Bull markets tend to find support at 10-month moving averages. When it breaks below the 20-month moving average, that's a big cautionary sign for us. The worst bear markets break below the 80-month moving average, and this happened to the S&P 500 in 2002, for the first time since 1973-74. That should give you a feel for how bad this bear market has been.
The other component we use is so-called wall-of-worry sentiment. Many times during the 1990s we had pullbacks accompanied by pretty fearful sentiment as measured by the put/call ratio — that is, a lot of put options relative to call options. What we find is that bull-market pullbacks generate a lot of fear. The bull market gets refreshed and renewed by shaking people off the wagon and moving money to the sidelines for a while, before the money comes rushing back. We started to see in 2000 a complete breakdown of that syndrome.
The sentiment analysis is useful not just to exploit the perversity of the market — that when people get very fearful that's usually good a time to buy, and when people get complacent it's usually a time to be worried. It also gauges the buying power available to support the market and the selling pressure that might come to bear. In a pullback, if a lot of people bail out, then those who were looking to sell have already sold. This creates a cash buildup ready to come back into the market. Similarly, if you see a pullback like we had off the 2000 top, with complacent sentiment, it's an indication of what's happening with the money. People are holding fast. Not bailing means, first, that there could still be plenty of selling to come, and second, that the cash available to support the market has not been replenished significantly.
SM: What does watching options tell you about the market?
BS: There is no better way to get a proxy for what investors are thinking than to see what is going on in the world of options. It helps you determine if the market is in wall-of-worry mode or the so-called slope-of-hope mode. Unfortunately, it has been in slope-of-hope mode since 2000. Options are my trustiest indicator.
Options data are divided into call activity and put activity. The activity on the call side is generated by bullish people, and the activity on the put side by bearish people. I can look at the ratio of put-to-call volume and get a feel not for what people are saying about the market, but for what people who are participating in the speculative end of the spectrum are actually doing.
The October [9] bottom is a perfect illustration. Three weeks of rallying is all it took to get this huge shift to being bullish again. To me, that is the slope-of-hope mentality. Bear market rallies generate a lot of positive thinking, suck in money off the sidelines, then...boom! The bear market resumes and investors are left holding the bag. The most noteworthy thing about this bear market is the bullish sentiment that is generated every time we bounce off a bottom.
SM: What is the VIX and why do you follow it?
BS: The Chicago Board Options Exchange Volatility Index, or VIX, measures the prices that traders of index options, specifically the S&P 100 index, are willing to pay for puts. It's the urgency to buy puts that drives the overall level of options premiums and that determines the direction of the VIX. It's been in use since the early 1990s, but the CBOE back-calculated it to the mid-1980s. It was 170 on the day of the October 1987 crash.
I think we coined the phrase "fear barometer." When the market declines with urgency, it invariably results in a clamor in the options market to buy puts, either to protect portfolios from further damage or to speculate on further declines. Selling begets selling and heavy selling creates fear.
VIX 101 calls for a climactic high at the end of a bear market. The argument is, sentiment has reached some kind of bearish extreme and, therefore, the market should be buyable. That's what happens at short-term bottoms: Investor fear spikes higher, then dissipates. It happened in September 2001, July 2002 and October 2002. Interestingly, with each successive bottom, the VIX peaked at successively lower levels. To a sentiment analyst, that doesn't feel very good. You'd like to see the market keep plunging to new lows as the fear level, as measured by the VIX, builds. It doesn't have to go to 170, but you want the VIX in October to be higher than July. The peak in October 2002 was 50.
SM: What is the VIX telling you now?
BS: It's a very mixed picture. On the one hand, we have an unsatisfying series of lower highs on the VIX. I don't like that. On the other hand, its 10-week moving average peaked in mid-October at about 40. This was the third-highest 10-week moving average on the VIX since it's been calculated. We got one at 40 in October 1998 and in November 1987 it got to 50. If you forget about single point readings and stretch it out over this July-to-October period, we've had an average reading on the VIX that has been pretty impressive. So that's why I call it a mixed picture. On a 10-week-moving-average basis, you could call that bullish.
I feel that a bias toward best-case-scenario thinking has been characteristic of this bear market. We're reading from Wall Street analysts or economists that the first half of 2003 will be no great shakes, but wait until the second half. This is the third year in a row we've heard this scenario. That's endemic to bear markets, that wishing and hoping.
I have a pretty heavy position in gold stocks. They might be a little overbought, but what I like about gold shares from a sentiment perspective is, if you look at the dollars in the Fidelity Gold Sector fund (NASDAQ:FSAGX - News) and you compare that to the total dollars in their sector fund complex, it's actually below mean for the last 15 years. There has been no big rush into the gold funds by the people who trade these funds.
SM: Where do you see the market in the next 12 to 18 months?
BS: I'm long-term bearish on stocks. My short-term bullish call, made in November, probably has no more than a month left in it. I feel that through mid-January, from individuals and institutions, we'll see more toes stuck in the water thinking the worst is behind us. We're going through one of those periods where the market starts sucking in additional dollars before it goes down again. I think during the first half of the year, into July, there will be a point that will bring disappointment on the progress of the economic recovery and on the earnings front. Once we realize that on several different metrics, we're still overvalued, we could start another downside leg. I think this downside leg will be led by the safe haven stocks, the large-cap stocks in the Dow.
Of all the indices, I see the Dow being the most vulnerable. The Dow is 20% to 25% above its long-term relationship with the S&P. For many years, it didn't matter if you looked at the Dow or S&P, because their performance was essentially equal. Throughout the late '90s, the S&P outperformed the Dow because of its bigger tech component. Since 2000, the Dow has blown the doors off every competing index. The Nasdaq was chopped 77% and the S&P lost 50%. We haven't seen scary numbers on the Dow. It's not unreasonable for the Dow to be chopped 50%. I think it might hit the 6000 range by midyear, or the third quarter, of 2003.
Look at the 1973-74 bear market. We had a nice rally off that bottom and then went into five years of doing nothing. There's a difference between a market that stops going down and one that's achieving aggressive gains. I don't know that enough people are making that distinction. It could stop going down and still be an unexciting and unprofitable place, like it was in the late 1970s and early 1980s. There is no law saying you bottom out and then "V" into a new bull market. I think there's still the rush to turn bullish — the thinking that the train is leaving the station and you don't want to be left on the sidelines as the Dow goes back to 12,000. Maybe that mentality has to dissipate for the market, ultimately, to bottom out.
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