Pessimism Is Excessive, Depending On Your Perspective

Posted At 8:45 AM EST

Good morning...We begin the day with aggressive buying interest in the pre-market futures, with sustained pressure right from their opening on Sunday afternoon.  Scheduled economic and earnings-related news is extremely modest this week, with the fewest major (economic) releases we'll see all month.

A few weeks ago, I asked for feedback on potential changes to the reports that are sent out most mornings, seeking to find out what would be most useful to you.

I've finally sorted through all of the responses (thank you!) and here are the conclusions:

1.  An earlier, briefer morning report got an overwhelmingly favorable response.  This would be sent well before market open, focused less on commentary and more on actionable data for the coming day, with brief highlights on any notable changes in our indicators, and "bottom-line" outlooks similar to those below.

2.  Ad hoc research reports, similar to the longer commentary contained in these Morning Market Comments, would be welcomed during the day as they come up.  You would be able to opt in or out of receiving them.

3.  A weekly wrap-up is also on tap.  This would contain no new research; it would simply be a summation on what was reported during the week.  This way, if you keep up with what's sent during the week, you wouldn't miss anything in the wrap-up, but if you have a longer time frame and don't care for daily updates, this weekly report would be enough to keep you in the loop.

4.  PDF formatting was a mixed bag.  Most were in favor, but several were adamantly against - usually due to the inability to read it on mobile devices.  PDF is great for allowing flexibility in formatting, but I understand the concerns against it and will almost certainly keep the emails in HTML format.

Thanks again for letting me know what you find useful and I'm looking to institute these changes by December 1st.

Early last week, we took a look at Rydex traders, and showed how they were still interesting in buying the dip, with a continued focus on the most bullish index funds that Rydex offers, as opposed to the most bearish funds.

That started to change late last week, and by Friday they had significantly more assets in the leveraged bearish funds than they did in the leveraged bullish funds.

This is the fourth time they've done this since the July low, each under somewhat similar circumstances - they got too bullish after trying to buy a dip after a new high, they turned very bearish after the market rallied and approached a previous high, then they covered those shorts as the market sustained a breakout.  Rinse, then repeat.

The current bull / bear ratio is the lowest since July 16th, and based on the pattern since July at least, it argues for a continued run at a new recovery high for the S&P.

That kind of pessimistic attitude was also reflected in a couple of indicators we looked at last week with the AAII sentiment survey and a bump up in volume among inverse ETFs as a percentage of total volume.

In the options pits (or options screens more accurately nowadays), last week saw a similar increase in bearish bets among the smallest of options traders.

These mom-and-pop options traders spent 22% of their total volume on protection by buying-to-open put options.  Surprisingly, that's the 2nd-highest amount since the spring market bottom, barely edged out by the week ended July 10th.

While that's suggestive of a pessimistic extreme among wrong-way traders - and a likely continuation of the market rally - it's worth keeping in mind that unlike what we saw in July, there wasn't much of a drop in speculative call buying last week.  These guys and gals still spent nearly 34% of their volume buying call options, unlike July when call buying accounted for less than 30% of volume.  That's why the ROBO Put/Call Ratio isn't as extreme now as it was in July.

And, while spending 22% of volume on put buying does coincide with periods of excessive speculation since the March bottom, over the past few years we saw this ratio spike into the 25% - 30% range as the market corrected.  So it's all a matter of perspective.

So it's mostly a matter of the market environment.  If we're still in an impressive recovery phase as has been evident for the past few months, then the kind of sentiment we've witnessed over the past few days should be enough to sustain another run at new highs.  If the momentum has petered out enough that a more intermediate-term decline is on tap, then we're likely in for the deepest pessimism we've seen since the spring.

There have been a few warning signs of the latter scenario (an inability to rally immediately from short-term oversold signals, a break of major uptrend lines, a lack of sustained momentum, terrible breadth statistics), but it's really hard to argue with the fact that we've seen five consecutive up days and an overall uptrend that refuses to break.  How the S&P 500 reacts around the 1070 - 1080 area it is threatening to challenge today should tell us quite a bit about which scenario has the upper hand.

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Intermediate-term Signal Strength:    Neutral since Apr 9th (843 SPX)

(click here for archive)

Beginning in early March, we discussed a large number of reasons to expect an imminent rally of one to three months' duration, or possibly even a new bull market.  During April and May, we went over several studies that suggested that "this time is different" in terms of bear market rallies, as we reiterated in early May.

Since July, the market has consistently rallied smartly from the shortest-term oversold readings, as a healthy market does, and it has rolled over almost all hints of bearish conditions.  That kind of momentum tends to persist for long periods of time.

We've seen some periodic bouts of excessive optimism along the way, and the market has pulled back in the very short-term after them.  But each time, the major indexes have held technical support, and rallied from even intraday oversold readings, so we've seen little change in the uptrend's character.

Over the past week or so, we've gone over a few modestly convincing studies that show some cracks in the uptrend's potential.  We're seeing some very volatile swings in breadth, a deterioration in the number of stocks rising along with the market, a number of big reversals after tests of recent highs, and a hesitation to rally from short-term oversold readings.

All of these were warning signs, and now the S&P 500 has violated its uptrend from the March low.  It is still showing a series of higher highs and higher lows, and will until it drops below 1020, but the intermediate-term trend has lost one leg of its bullish stance.

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Short-term Signal Strength:  Neutral since Oct 5th (1029 SPX)

(click here for archive)

Pretty much everything I look at in the short-term is throwing off neutral or inconsistent readings.  The S&P is stuck within a broad trading range, and most of our more sensitive indicators are mixed.

There are some measures which have a bit of a longer-term, such as the Rydex data mentioned above, that argue for higher prices, and today should go quite a ways to determining if that will hold true this time.  With the S&P poised to gap open right into the teeth of where it broke down a couple of weeks ago - on a Monday no less - if buyers are eager enough to close the market higher than where it opened, then it should pave the way to a challenge of the recent highs.  If not, then we should fade early, within the first hour.

So that will be my main focus for today, with a higher high after the first hour most likely leading to still-higher prices ahead.

All the best,