Sector Investing

[ReturntoSender]

Sentiment Journal: Bulls Back on Defense Frederic Ruffy, Optionetics.com
January 4, 2008

http://optionetics.com/market/articles/18778

Market Internals: Stocks are back under pressure, with the Dow Jones Industrial Average ($INDU) suffering triple digit losses during three of the past four trading sessions. Through midday Friday, the Dow had given up 475 points on the week and slipped back below the 13,000 level. Market internals on the New York Stock Exchange [NYSE] have been poor. While turnover has been light due to the holidays, the high volume day was on Wednesday when the industrial average plummeted 220 points. Meanwhile, market breadth, as measured by the NYSE advance-decline ratio, has been negative during four of five trading sessions. Up volume trailed down volume every day during the holiday-abbreviated week of trading.

The action on the NASDAQ Stock Market isn’t inspiring much bullishness either. The NASDAQ Composite Index ($COMPQ) has lost ground during six consecutive trading sessions and has given up 190 points, or almost 7 percent, during that time. The tale of the tape paints an equally somber story. Market breadth on the NASDAQ Stock Market has been negative during five of the past five trading sessions. The ratio of up to down volume has also been negative for five days straight.

Sentiment Indicators: To say the market action over the past two weeks is disappointing for the bulls would be a gross understatement. For one, the “Santa Claus Rally,” which is a historically strong period spanning from December 25th to January 1st, failed to lift the market during the last week of December. In addition, the first five days of January, which is also a seasonal strong period, has disappointed as well. During the first three days of 2008, the market has seen one day of lackluster action and two days of heavy selling.

Consequently, investors are back on the defensive and risk perceptions are rising once again. As evidence, the CBOE Volatility Index ($VIX), which dipped to multi-month lows in late-December, is up in six of the past seven trading sessions and hit an intra-day high of 24.30 on Friday, or its best levels since December 18. The market’s “fear gauge” is up nearly 30% from its late-December low. The NASDAQ Volatility Index ($VXN) is up from 20.9 to 28.84 during that time, or roughly 38%.

Heavy levels of put volume accompanied the jump in the VIX. For example, in midday trading Friday, more than 600,000 puts on the iShares Russell 2000 Index Fund ($RUT) had traded, or more than three times the call volume. Active trading was also seen in the S&P 500 Index ($SPX), the S&P Depositary Receipts (SPY), and the PowerShares NASDAQ 100 Index Trust (QQQQ). The fact that put volume was increasing along with the volatility gauges offers confirmation that investors were scrambling to hedge stock portfolios—fear had set in.

Mutual fund investors seem to be a bit more bearish as well. According to AMG Data, stock funds saw net outflows of $8.3 billion in the week ended January 2. Meanwhile, the sentiment surveys also report a decline in bullishness. For example, the American Association of Individual Investors reports that only 25.71% of those polled are bullish and 55.24% are bearish, which compares to 30% bullish and 50% bearish the week before.

At this point, it might be reasonable to assume, from the extreme readings from a number of sentiment indicators, that investors have overreacted somewhat. The recent decline has stirred up a bit too much bearish sentiment and the market is now oversold. However, while it is possible that the market might find a bottom in the near future, the technical action of the market is deteriorating, while bearish sentiment is still rising. This dangerous combination is a powerful force that can push stock prices lower still. In fact, it might take further selling and an episode of “capitulation” to form the foundation for the stock market’s next major advance.