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SENTIMENT JOURNAL: Bullish Extreme?
By Frederic Ruffy, Optionetics.com
7/22/2005 4:45 PM EST

http://optionetics.com/articles/article_full.asp?idNo=12888

Market Internals: Stocks bounced around on increasing volume, but failed to make any progress during the latest week of trading. The Dow Jones Industrial Average ($INDU) rose three times and fell twice to finish the week approximately ten points higher. Market internals on the New York Stock Exchange [NYSE] were mixed, but with a modestly bullish bias. For example, advancing issues beat declining issues during three of five trading sessions. Similarly, up volume exceeded down volume three times. The NYSE New High New Low Index [NHNL] also improved. It rose from +98 last Friday to +199 (with 209 stocks setting new 52-week highs and 10 falling to new 52-week lows).

Meanwhile, the Nasdaq Composite Index ($COMPQ) rose 21 points or 1% on the week. A 28-point rally on Tuesday propelled the Nasdaq into positive territory. From that point forward, it was chop, chop, chop, with no meaningful movement in the index. Yet, market internals on the Nasdaq Stock Market were mostly positive with advancers beating decliners nearly two-to-one Tuesday, Wednesday, and Friday. At the same time, the ratio of up to down volume favored the up variety during three of five trading sessions this week. Even Thursday, when the Nasdaq suffered a ten-point loss, up-to-down volume was almost even. In short, money is still flowing into the Nasdaq, volatility remains low, but volume is picking up, and the technicals remain bullish.

Sentiment Data: Market sentiment was little changed after this week’s sideways trading. Overall, the indicators point to relatively high levels of optimism and bullishness among investors. For example, the CBOE Volatility Index ($VIX) remains near multi-year lows. The market’s “fear gauge” edged up to 10.52 from 10.33 the week before. The Nasdaq Volatility Index ($VXN) tumbled to new all-time lows of less than 13%. The low readings from the VIX and VXN suggest that investors, particularly options traders, don’t expect the market to exhibit much volatility in the short-term.

Meanwhile, call volume remains heavy. Thursday was the busiest non-expiration related volume day of the month with 6.8 million contracts trading on the six US options exchanges. Nearly 4 million call options traded. At the same time, the International Securities Exchange Sentiment Index [ISEE] rose to 208, which indicates two times more call than put purchases on the largest stock options exchange. In short, options trading volume is on the rise and a good chunk involves call purchases—another sign that bullish sentiment is on the rise.

The sentiment surveys show bearishness creeping a bit higher. According to the latest survey of sentiment from the American Association of Individual Investors [AAII], bullish sentiment is now 41.18%, compared to 57.89% last week, while bearishness jumped up to 27.45% from an extreme low of only 14.04%. Investors Intelligence reports that 52.7% are bullish and 23.1% are bearish. Therefore, despite an uptick in bearishness, the surveys are still lopsided in favor of the bulls.

Short interest is falling. According to The Wall Street Journal (“Short Interest Declines as Bears Reap Their Gains,” July 22, 2005, by Peter Mckay), short interest on the New York Stock Exchange fell for the second consecutive month in the period ended July 12. Through the end of June, the average short only portfolio was up 4.7%. Some of the bears might be taking money off the table and turning a bit more bullish.

Mutual fund investors are certainly remain bullish. According to AMG Data, stock fund investors added $5.00 billion to equity funds during the two weeks ended July 20. The inflows this month follow $8.2 billion in June, $13.6 billion in May, and $6.6 billion in April. The flow into mutual funds indicates that investors are still willing to add to their stock funds even though the market has not been producing strong results. The inflows are also an important source of liquidity, as it gives the trillion dollar mutual fund industry fresh cash for more stock purchases.

Overall, not much has changed in the latest week of trading and we will conclude Sentiment Journal with the same remarks as last week. Sentiment has clearly shifted during the past few weeks and there is some evidence that bullishness has become somewhat extreme. From a contrarian view, it is indicative of overbought conditions. Yet, we know from experience that an overbought market can stay overbought. Bullish sentiment can fuel more liquidity and volume into the stock market. Therefore, it is dangerous to bet against the trend. Instead, strategists with a bearish bias will want to wait for signs that sentiment is beginning to shift again. Or, wait an extremely bearish (and unexpected) fundamental event to stir up market angst and bring news bears back onto the scene.