Speculative Juices Draining From The Market

03/12/09 9:00 AM EST

Good Thursday morning...We begin the day with a flat reaction in the pre-market futures as some early weakness was overtaken by economic news that was a little better than expected for a change.

Last week, we looked at a chart from the InsiderScore.com service which showed that corporate insiders at S&P 500 companies were showing an extreme bias towards buying stock versus selling.

During the latest week, that skew in activity has broadened out, and is now less concentrated in large-cap stocks and is more evident in stocks comprising indices like the Nasdaq 100 and Russell 2000.  That has pushed the overall measure that we update weekly on the site to the third-most-extreme level we've seen.

The weeks of November 19th and 26th exceeded the current pace of buying vs. selling, but not by much.  And it's notable that the week of the 26th was a 30-year high.

While corporate insider volume has been expanding into technology and other sectors that hadn't seen much of it lately, traders in general have been focused more on NYSE-listed issues than ones listed on Nasdaq.

The chart below shows the ratio of Nasdaq to NYSE exchange volume that we update daily on the site.  I usually watch for the ratio to dip below 1.0 (more NYSE volume than Nasdaq volume) to signal an extreme in risk-aversion, and we haven't quite made it there.

Still, the chart below highlights other times since the bear market began that the ratio reached either the current level of risk-aversion (green arrows) and risk-taking (red arrows).  Not perfect, but it was a pretty good contrary indicator.

That risk-aversion can also clearly be seen in the level of volume in Over The Counter (OTC) volume.  These are also known as "pink sheet" or "penny" stocks because price quotes for them used to be printed on pink paper, and they generally trade for under $1.

By watching the volume of trading in these issues, we can get a pretty good handle on the speculative juices raging in the market.  If you take a peak at the total dollar volume in these stocks at the height of the 2000 Nasdaq bubble, it's clear that those speculative juices were flowing harder than tween spirit at a Jonas Brothers concert.

Not so much recently.  Just-released figures show that the total number of pink sheet trades stood at 321,000 in February, down from 650,000 a year ago.  And the total dollar value of those trades decreased to only $511 million, a third of what it was last year (and down from $28 billion in March 2000).  The current dollar volume is a new record low going back to 1995.

Bottom line - Intermediate-term

Heading into last week, we went over a number of indicators and studies that suggested we were very likely within days of an inflection point.  By Tuesday and Wednesday, we had a good-looking setup - sentiment had reached an extreme (the setup) and the price pattern coincided almost perfectly with past lows (the trigger).

The market failed to follow through immediately, instead continually flirting with that 681 area that marked last Tuesday's late afternoon low in the futures.  Despite intraday forays under that level, both Thursday and Friday closed above it.  We dropped just below it at Monday's close, but now we've closed back above yet again.

This is a messy pattern, but still basically within the confines of the risk parameters mentioned in the past studies.  From here, it would help to see some short-term follow-through.  In the table from Wednesday that listed other "blast off" days, the S&P was higher three days later 7 of the 8 times by an average of +3.8%.  The one failure (briefly) led to a lower low before following through on the upside, but obviously that was an outlier and less desirable for anyone holding long positions.

According to the study from Tuesday, it's been more than a year since we've seen a rally last longer than 80 days, so as much as we're ever "due" anything, we seem to be due that.  Based on everything we've discussed over the past two weeks, the probability seems extremely high that we have reached that inflection point and we will see higher prices over the coming month(s).

My take going into yesterday morning that maximum risk was down towards the 640-660 area, but after Tuesday's show we should not see a lower low from here, beyond Monday's low of 666, especially more than for one or perhaps two days.

Bottom line - Short-term

Yesterday I mentioned a couple of troubling short-term signs, including the "excessive optimism" readings in the STEM.MR Models and our other most sensitive guides, and the market's recent tendency to fade from opening gaps following big up days.  My take was that any move toward 740 on the S&P 500 yesterday or this morning would get turned back on the first attempt.

The S&P did get as high as 732 before fading, but I'm not sure if that's close enough to be considered the first test or not.  I would have preferred more of a rally closer to that area that generated even further extremes in the short-term indicators to trigger a possible (very short-term) short trade, but no such luck.

Now we're left with no real extremes in the indicators, except put/call ratios which remain stubbornly and disturbingly complacent (even accounting for the skewing effects of "lottery ticket" call buying on financial stocks and the impact of inverse ETF volume).

It will be more difficult now to generate overbought readings again, but if we would happen to see another rally that couldn't make it above 740 that trigger another round of overbought readings, I would consider shorting against that level again.  I'm less inclined to do that now, since I'm unsure whether yesterday morning would qualify as the first test of that breakdown area - the first test almost always fails, the second test less consistently so.

As for buying, on a short-term basis I would of course prefer to see less enthusiasm in the put/call ratios, and generally would prefer to reach oversold in the short-term indicators we follow.  That's kind of a "careful what you wish for" thing, however, because if we do see the kind of weakness that would generate oversold readings, it would violate some of the bullish precedents we've discussed.

For the moment, I'm not doing anything trading-wise as the bulls face probably the biggest test of the bear market in the coming days.  I do think it will resolve to the upside when looking at the intermediate-term, not so sure short-term.

All the best,