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Price vs. Sentiment



Back in September, I noted how the structure of the market had changed, and as far as I was concerned we were no longer in a bear market. That changed my thinking from one of preferring to sell into overbought conditions to one of buying into oversold ones. There is nothing I see so far that changes that outlook, and based on many types of price-based studies I've done over the past months, the signs are plentiful that we should see higher prices yet this year.

As one example, Snoop Tone asked me to look at streaks where the Dow Jones Industrial Average didn't close more than 0.5% below a previous close. As of yesterday, we're on day 22. Historically, this is not terribly rare, as there have been 96 such streaks since 1897. The last one we've seen was in 1996, and the longest was an incredible 54 consecutive days in 1957. In fact, the current streak isn't even "average" yet, as the median number of days in prior streaks was 25 days. Generally, the results were inconclusive, but in the past it certainly was not a good sell signal. The market performance 1, 3, 6, 9 and 12 months later was consistent with any other random period. It did mark some exact tops (1965) but it also kicked off some tremendous bull runs (1985).

As another example, the S&P recently had a string of 13 consecutive days with higher lows than the day before. Since 1964, there were 30 other occurrences of similar streaks. 60 days later, the S&P was higher 28 times, for a "success rate" of 93%. Other studies, that looked at levels of extreme bullishness in some of the sentiment surveys, or how long the S&P has been more than 5% above its 200-day average, have concluded the same thing - we are in a very unique market environment, and historically those have not ended very quickly.

That said, I am extremely concerned about the current sentiment situation. Like everyone else it seems, I am expecting about a 3%-8% pullback in the S&P over the coming weeks, as the speculation we're seeing now hasn't been seen in several years. Some examples:

• Very small options traders (those trading 10 contracts or less) have been buying calls to open at a pace nearly three times that of puts, something not seen since the height of the bubble. Last week, larger traders (those trading at least 50 contracts) concentrated 27% of their volume on protective put purchases, and the only week since 2000 that matches that kind of spread between the two traders was the week ended December 28, 2001, close to the end of that upmove.
• Most of the breadth figures I watch are extremely stretched. While that doesn't say anything about the long-term, it usually does result in some kind of short-term retracement, even during uptrends.
• Many of the sentiment surveys are at historic extremes. Recently, the Consensus survey recorded a number of bulls that had only been exceeded three other times in the past 17 years. Other surveys covering different demographics are showing similar amounts of truly overwhelming bullish opinion.
• Volatility, both historical and implied, are scraping along at multi-year lows. That certainly can continue for long periods of time, but it leaves us vulnerable to swift, sharp declines. If few traders are pricing in shocks to the system, what happens if one comes along?

Also, it would be unusual to not see some type of correction in January. For 15 out of the past 18 years, the NDX has undergone a correction of at least 5% within 10 days at some point in January, and most of the time the high was formed before the 12th trading day of the month.

For these reasons and more, I feel that the risk/reward right now is skewed to the downside. That means I am willing to use higher prices to fully protect long positions, or even scale into shorts for a trade. However, even with the sentiment situation we have now, I don't fully believe this bull run is over. I don't set price targets, so I don't have a guess as to how far we'll go, but similar to what I outlined in September, I would need to see the price structure change to something other than what it is now, which to me is unequivocally positive.

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