Trader’s Narrative

From recent option sentiment readings we have reason to believe that after a fantastic “Santa Claus rally” the market is entering thin air territory - at least in the short term. To that we can add an important technical indicator: the McClellan Oscillator.

If you’re unfamiliar with it, it is simply a measure of underlying breadth and is calculated by taking the difference of advancing and declining issues and then using this net breadth to calculate 39 day and 19 day exponential moving averages. The oscillator is then calculated by subtracting the former by the latter.

You can calculate this oscillator for any market and for each it will display different characteristics but usually, +100 is considered overbought and -100 oversold.

Here is the McClellan Oscillator for the NYSE:

I would take this chart with a grain of salt because over the years, a larger and larger portion of the issues traded on the NYSE is attributed to non-common stock securities like bonds, CEFs, municipal bond funds, preferreds, etc. But even so, the McClellan Oscillator is off the charts!

And this is the McClellan Oscillator for the Nasdaq:

It is important to note that this technical indicator compliments the view that option traders provide because they are both short to medium term in nature. It wouldn’t make much sense using a long term indicator, like say, the Coppock Curve to confirm a short term indicator - or vice versa.

Book Giveaway
If you haven’t already, throw your name into the hat for a giveaway of:
An American Hedge Fund.
The contest will close this Friday.

Welcome to 2009 and the first trading day of the new year!

The last sentiment overview of 2008 didn’t paint a pretty picture. And it seems that things have continued to deteriorate from there.

CBOE Put Call Ratio
Here’s a chart of the 15 day simple moving average of the CBOE put call ratio (equity only):

Unless you zoom out you will miss that in the past few years this indicator has fallen into a rather clear upward channel. In light of this channel, we are now very close to a bearish low for the put call ratio. As you can see, in the past this has coincided with very weak markets going forward.

ISE Sentiment
Surprisingly, just before the stock market got a year end boost - the S&P 500 rising from 870 to 930 - the ISE Sentiment index reached 206 on December 29th 2008.

The last time the ISE Sentiment index was close to this level was back on October 29th 2007 when it reached 192. Before that, the last time the call put ratio was above 200 was in May 2006, just before the market entered a period of weakness lasting until October of the same year.

If we look at the equity only ISE Sentiment data, the recent top came on the second to last day of trading of the year, on December 30th 2008 when it reached 234 - meaning that retail option traders on the ISE exchange bought over twice as many call options as put options. The last time this bearish level was surpassed was in October 2007. So obviously this is an ominous warning for anyone who is long this market.

Here’s a chart of the ISEE sentiment ratio (equity only):

Silver Lining
The only bright spot I can find in sentiment land is the recent data regarding portfolio allocation from the AAII. I’ve mentioned this before back in the sentiment overview for the week of October 3rd 2008.

According to the survey respondents at AAII, in October of last year, the retail investor in the US allocated 35% in cash, 51% equities and the rest in bonds. They have now moved to 42% cash and only 42% equities (and the rest in bonds).

This is significant because for the whole history of this indicator, retail investors have never allocated as much (or more) cash as equities. Clearly, this shows a despondency which contrarian investors spend most of their days sighing for in vain.

Although we have now surpassed any historical equivalent of an extreme for this sentiment indicator, it is interesting to note that the last two times that the allocation for cash and equities came close (but didn’t match) was in late 1990 and late 2002. Both brilliant spots to put cash to good use.

This dovetails well with some other reasons already outlined for long term optimism. It seems that we are in for a rough patch in the short term but clear sailing for those who will grit their teeth and bear it. No pun intended

If you would like to receive a free copy of Tim Syke’s book, An American Hedge Fund, leave a brief comment below (making sure you leave your correct email). I have TWO copies to send to two of my randomly chosen readers as a Christmas [slash] Hannukah [slash] New Year’s gift.

Timothy Sykes’ book An American Hedge Fund takes you through a conversational, breezy account of how he took $12,000 of Bar Mitzva money and traded it to $1 million. Although Tim peppers his book with specific trades, the book doesn’t have any charts. This is disappointing because it would have been so enriching. Maybe for the second printing

While I respect and admire Tim’s drive as a trader, I can’t help but think it was sheer luck that he didn’t completely blow up before he made serious money. Although the story takes place during the tech bubble of the late 1990’s, when turkeys flew like hawks, his complete disregard for risk is breathtaking.

The string of luck catches up to him when he sinks 33% of the capital under his management into Cygnus (now Accesso) a private company that later in the story goes public on the pink sheets. This is not only a continuation of his disregard for risk management, it is a colossal style drift, taking him from trading short term price patterns to long term investment into an illiquid holding.

I don’t recall every reading about any thought of capital allocation or money management. That is, measuring trades using R to standardize the risk that was taken to provide the resulting return.

To Prop or Not to Prop
After his initial success, while considering the options available to move him away from casual trading to a more serious undertaking, Tim decides against joining a proprietary trading firm because it “would only serve to increase [his] risk, not reduce it.”
Continue reading ‘An American Hedge Fund: Book Review & Giveaway’

There a few ways to take advantage of the January effect this year:

Small & Micro-Cap ETFs
The simplest would be to buy small cap stocks or ETFs before the year end and hold until they have a pop. Since the definition of “small-cap” has been continuously revised up over the past few years, it might be a good idea to look at “micro-cap” stocks. Here are a few ETFs:

• iShares Russell Microcap Index (IWC)
• First Trust Dow Jones Select MicroCap ETF (FDM)
• Powershares Zacks Micro Cap Portfolio ETF (PZI)
• Powershares Dynamic OTC Portfolio ETF (PWO)
• iShares S&P SmallCap 600 Index Fund (IJR)
• iShares Russell 2000 Index Fund (IWM)
• iShares Morningstar Small Core Index Fund (JKJ)
• SPDR DJ Wilshire Small Cap ETF (DSC)
• Vanguard Small-Cap ETF (VB)
• PowerShares Dynamic Small Cap Portfolio (PJM)
• PowerShares Zacks Small Cap Portfolio (PZJ)

Closed End Funds
Last week I mentioned a method to capture January effect alpha which uses CEF and specifically, municipal/bond CEFs. This year is a bumper crop for this specific strategy because of the vast number of these funds which have severe losses.

Value Line Futures Index
Yet another way to play the January effect is to use the Value Line Arithmetic Index futures. This is a little known equity index compiled by Value Line Inc. - the investment research outfit. It is comprised of approximately 1,650 stocks which are equally-weighted, as opposed to capitalization weighted as in the S&P 500 Index.

The futures for this index are traded at the Kansas City Board of Trade with each contract valued at $25 times the value of the index (appx. 1324). The Value Line January effect strategy is pretty straight forward:

Buy the Value Line contract (nearby month of course) and (sell short) equal value ratio of the S&P 500 Index. Close the position in the first week of January. Depending on the calendar, around the 9th of the month. That’s it.

This simple spread trade has a remarkably high profitability ratio but sadly it only comes once a year. And the advantage it has to the other two year end strategies is that it is market neutral. Although I suppose you could short SPY to offset a long position in small/micro-cap ETFs.

Here’s an interesting article from Barron’s Online today: The Best Way to Use the VIX

Bill Luby, editor of the blog, VIX and More, said, “A classic misuse of the VIX is as a market timing signal. The VIX is generally negatively correlated with the broad market indices, but this correlation waxes and wanes.”

This throws conventional wisdom a curveball right away.

He continued, “Further, investors tend to believe that absolute numbers for the VIX are sacrosanct, so that a VIX of 30 or 50 or 70 starts to take on a special significance [see Chart 1]. For the most part, my research and experience suggests that absolute VIX levels are much less meaningful than the current level of the VIX in relation to recent levels.”

This is something I’ve outlined more than a few times:

• Volatility Spikes Higher (But Not High Enough)
• VIX’s Distance From Moving Average Is Bullish
• The Volatility Index: It’s All Relative
• The Heartbeat of the Stock Market Goes Thump

Although looking at volatility through the prism of relative performance helps us to understand it better, it can still at times be elusive. This chapter of market history is just one of those times. What we have seen recently is such an outlier that even when we look at relative volatility, rather than absolute volatility, we still see an aberration worthy of extreme value theory. With one exception.

I looked at the CBOE NASDAQ volatility index (VXN) and compared it to its simple 150 day moving average. Here is where we are now relative to where we’ve been before:

In 1998, the distance of the VXN from its 150 day moving average peaked on early October, just as the market made the final low. In 2000, it peaked in mid April but the market was far from a lasting low. And that brings us to 2008 when the relative VXN peaked in late October.

My hunch is that during “normal” markets, the VIX and VXN provide great signals. But removed from a stair stepping bull market, things can easily become extreme and lose meaning. What we saw in early 2000 was the pricking of an asset bubble and its consequences. What we are seeing this year is the pricking of a credit bubble and its consequences. Until we once again see “normal” markets, the volatility gauges will be an interesting sideshow.