Sector Investing

[ReturntoSender]

SENTIMENT JOURNAL: August Angst
By Frederic Ruffy, Optionetics.com
8/5/2005 4:00 PM EST

http://optionetics.com/articles/article_full.asp?idNo=12979

Market Internals: Stocks traded mixed during the week’s first three trading sessions before giving in to a two-day sell off that drove the Dow Jones Industrial Average ($INDU) down 140 points. For the week, the industrial average rose two times, fell on three occasions, and gave up approximately 80 points. Volume on the New York Stock Exchange [NYSE] rose from week ago levels, but remains light for seasonal reasons.

Yet, although volume was lackluster and the Dow fell only 80 points this week, a significant amount of technical damage was done Thursday and Friday. During those two days, up volume exceeded down volume on the New York Stock Exchange more than two-to-one. The advance decline ratio turned more than two-to-one negative as well. In fact, on Friday, advancers trailed decliners on the NYSE more than three-to-one! Meanwhile, the NYSE New High New Low Index [NHNL] also caved it. It plummeted from +331 last week to only +33 (with 73 stocks setting new 52-week highs and 40 falling to new 52-week lows). In short, the weekly drop in the Dow was modest, but the modest point move does not reflect the deterioration in market internals witnessed during the past two trading days.

The Nasdaq Composite Index ($COMPQ) was not much changed during the latest week of trading either. After rising five points the week before, it fell five points in the latest week. However, market internals on the Nasdaq Stock Market took a hit as well with up volume trailing down volume during the past three trading days. The advance-decline ratio was also negative during the past three trading days. Finally, the Nasdaq NHNL took a turn for the worse. It tumbled from +207 to only +32, as 66 stocks rose to new 52-week highs and only 34 set new 52-week lows on Friday.

Sentiment Data: Prior to the market’s two-day sell-off, bullish sentiment remained quite high. For example, the International Securities Exchange Sentiment Index [ISEE], which measures call buying divided by put buying on the International Securities Exchange [ISE], spiked higher on Wednesday. It rose to +272 and not far from its 52-week high of +278. The high reading indicates that call buying was almost three times greater than put activity. In addition, the ISEE finished the day above 200 during four of this week’s trading sessions—including Thursday and Friday. The last time we saw this many days of +200 from this sentiment indicator was in December 2004, and just before the market’s decline that started in February. From a contrarian view, the high numbers are sign of heavy call buying and overbought market conditions.

Other sentiment indicators were also pointing to high levels of bullish sentiment. Last week, we noted that the American Association of Individual Investors [AAII] showed bullish sentiment is at 57.52% of only 17.65%. Investors Intelligence survey was 55.9% and 22.6%. This week, AAII reports 47.38% bullish and 26.09% bearish. Investors Intelligence is 57.3% bullish and 22.5% bearish. Therefore, according to the sentiment surveys, bullishness is still high.

Mutual fund investors are still actively adding to their equity funds. According to AMG Data, $3.52 billion flowed into stock funds in the latest period, which compares to $450.00 million from equity funds in the week ended July 27. Investors have been aggressively buying shares of stock mutual funds throughout the year and, while this can add to the market’s liquidity, heavy inflows is also evidence of increasing levels of bullish investor sentiment.

Yet, while high levels of bullishness paved the way for the two-day decline that started on Thursday, there are signs that sentiment is beginning to shift. For example, the CBOE Volatility Index ($VIX) is up from a low of 10.24 two weeks ago to its current levels near 12.5. The Nasdaq Volatility Index ($VXN) has rallied from July’s low of 12.5 to 15.4. The rise in the volatility indices is a sign that anxiety levels are on the rise.

Meanwhile, the CBOE put-to-call ratio stayed in a high range this week. The indicator measures put volume divided by call volume on the Chicago Board Options Exchange [CBOE]. It rose to a three-week high of 1.05 on Thursday. The ten-day average (below) is also rising. It is now at .88 compared to .82 two weeks ago. The move higher in the ratio is a sign that put activity is on the rise, as investors become more defensive and turn to put options for protection.

Overall, sentiment seems to be shifting and market internals are deteriorating—a dangerous combination. Last week, we noted that the technical action of the market remained strong and that it would take a major event to lead to a sudden shift in sentiment. This week, two key events weighed on the market—oil prices rising to new all-time highs and interest rates spiking to four-month highs. So far, these have not been major shocks or the type of events that we referred to. As a result, chances are that the latest decline is part of a pullback in a healthy trend. However, relatively high levels of bullish sentiment set the table for the decline. Therefore, the risk is that this is now a turning point and part of a more significant shift in market psychology. If so, stocks may continue to struggle until the tables are turned and the percentage of bears far outnumbers the number of bulls. In conclusion, it is probably a good time to look for profits in both directions, and to use strangles or straddles because the exciting months of September and October are just around the corner.