Market Briefs & Sentiment Outlook (MBSO)
Reported by Tony Carrion

http://www.market-harmonics.com

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February 7, 2010

In the last MBSO, we were looking for various indicators of market sentiment to reach levels that would signal a likely reversal in the upward trend in stocks since the March 2009 low.  A number of them reached those levels in mid-January, coincident with the decline in the stock market, which saw the S&P 500 fall 9% peak to trough.  We note below some of the changes that have occurred in sentiment trends since our December MBSO that we think investors should be mindful of, and some thoughts on the implications for stocks going forward.

Risk-Taking
Again, one of our favorite measures for risk-taking is the trading action in the high yield (aka junk bond) market.  We noted last time that the junk bond trade was getting crowded, as spreads between the 10 Year Treasury Note and the Markit iBoxx High Yield Index had narrowed substantially from the "fear-of-default" levels reached in the Fall of 2008.  One report we cited was a Bank of America Merrill Lynch survey published in December that indicated credit investors were “very bullish” on the outlook for debt securities in 2010, and that 53% of respondents were “overweight” high-yield debt.  Ironically (though consistent with the way market sentiment works) the "generational opportunity" to be long junk bonds was ignored by all but the savviest investors out of fear the spreads would continue to widen.  Consequently, by the time most investors were flocking to junk, the easy money had already been made.  Our two charts below show where things were in our December outlook relative to the high yield market, and where they are as of early February.

Updating our chart of the iShares iBoxx High Yield Corporate Bond ETF (symbol HYG), which tracks the Markit iBoxx High Yield Index, we speculated a higher high might still follow to resolve an apparent diagonal triangle pattern (in Elliott Wave parlance).  Diagonal triangles are formed when a trend is becoming exhausted, and end with a final thrust through resistance.  When complete, a sharp drop usually follows.  As the second chart indicates, HYG put in a Wave 5 top at 90.29 on January 12, which was within the 61.8% Fibonacci retracement of the advance off the March 2009 low.  The behavior following the completion of the diagonal was also consistent, with the ETF falling 7.6% peak to trough from the high.  Not surprisingly, risk spreads started to widen again, albeit mildly thus far.

When we showed this chart back in December, the spread between the 10 Year Treasury Note and the Markit iBoxx High Yield Index was just below 600 basis points, which has been the historical mean.  Coincident with another high in HYG, our view back then was for the spread to narrow further: "...our work suggests that a retracement at least towards 400 basis points is still likely.  The rise from June 2007, which represents the start of Wave (1), was also the low point for the data, at 257 basis points.  We suspect a bottom should occur somewhere between these levels."  The spread fell to 485 basis points on January 13, possibly ending the second Wave (C) in our Elliott Wave model above, although we still can't rule out a further narrowing in the spread if HYG recovers from its decline.  An oversold rally may be likely anyway, so the key will be how much of the Jan-Feb decline is retraced.  

On a more secular basis, the bigger issue is whether the credit market is signaling another sea change in sentiment towards debt.  That would ultimately imply a decline in investor appetite towards risk-taking, the effects of which would ripple out to other markets.  It's perhaps premature to know whether such an inflection point is at hand, although certainly the time to raise the red flag is.

Volatility & Complacency
As stated in the previous MBSO, "Even with the VIX Index having fallen 80% from its October 2008 peak, it wouldn't surprise us to see that old gauge of market fear and complacency get even lower."  This seemed likely just based on the frothy sentiment being reflected in the VIX at the time.  For some perspective, the VIX fell from 19.47 where it was trading on December 24th, to an intraday low of 16.86 on January 11th, achieving just over a 90% retracement towards its historic low of December 2006.  With the subsequent downturn in the market, the VIX rose as sharply as 29.22 on February 5th, a fairly massive move in a short space of time, and also perhaps signaling a key inflection point of more than near-term significance.  

We update above our chart of the VIX Put/Call Ratio overlaid with the S&P 500.  Because options are traded on the VIX to allow investors to hedge against volatility risk, the VIX Put/Call Ratio (which moves inversely to the VIX index and S&P) is a useful read on the market's expectations for higher or lower volatility.  Put buying reflects expectations for a lower VIX (bullish) and call buying reflects expectations for a higher VIX (bearish).  We use a 14-day moving average to smooth the VIX Put/Call data.  As our updated chart shows, a significant drop in the VIX Put/Call Ratio on massive call buying of VIX options has accompanied the decline in the S&P 500 since mid-January.  Note that the falling ratio has yet to retrace the dip that occurred during the June-July 2009 stock market decline, which is still a possibility.  At any rate, a falling VIX Put/Call Ratio tends not to be good for stocks.

More Messages From Options Traders
Besides the VIX, how else are options traders placing their bets? Again, we look at data based on the All-Equities ISE Sentiment Index, which differs from the CBOE Equity Put/Call Ratio in that a rising trend is bullish.  The ISE version also focuses on buy-to-open options, so it offers a good picture on which way the majority of options traders are leaning.  

Our chart above shows the 14-day moving average of the All-Equities ISE Sentiment Index, which reached yet another all-time high in bullish sentiment on January 19th, the same day the S&P 500 made its recent top.  Although the drop in the readings is clearly evident, it remains troubling that the sentiment readings are still closer to their highs than at the more pessimistic levels that preceded strong market advances.  This leaves open the prospect that the readings will ultimately get lower, and the market along with them.  

In the last edition, we also introduced a variation on the All-Equities ISE Sentiment Index, based on a harmonic averaging of the intraday ISE options data for equities.  Again, the sentiment index data for the ISE is based on the closing number for the day.  As we've found, there can be huge variances between the opening and closing readings, so we apply harmonic averaging to the full day's data to determine where sentiment was mostly leaning. For those recalling our comments last month, we were looking for signs of a flattening (and ultimately a downward inversion) in the green regression line, as the R-squareds got lower.  This has been happening, although at a snail's pace.  Consequently, what this tells us is that bullish sentiment hasn't waned very much despite a 9% correction in the stock market, and also helps explain why the readings in the All-Equities ISE Sentiment Index have tended to remain closer to their highs.  Some would argue that a 10% decline had already "been discounted" by the market, which is precisely the point.  The lack of any fear still indicates investors remain complacent.

What Exactly Have We Been Correcting?

While we're not necessarily looking for the same outcome, we still note that on a percentage basis, the recent 9% decline in the S&P 500 was not unlike that which occurred between June-July last year.  When the index touched its 200-day moving average on Friday, February 5 (as seen above) it set off a furious short covering rally, suggesting at least a short-term low could have been hit.  As to whether it is more than that, or simply a pause within a much bigger decline is one of the things we need to consider.  A key for the moment is whether any bounce that ensues is capable of removing resistance at 1104.  An upward violation of this resistance could change the wave style of the decline, with perhaps a similar outcome to last summer.  While there are some problems with this on the probability scale, it's still possible, and one thing we'll be watching for.  Then there is the question of whether the decline is in fact retracing the full rise since March 2009.  If so, the minimum expected retracement would be in the neighborhood of 965 on the S&P.  Lastly, and in terms of the "big picture," is the secular trend playing out in the markets, and whether the bear rally (which we still call it) from the March 2009 low itself has topped.  The various sentiment measures we've discussed still appear relatively early in their pullback trends, and are certainly nowhere near the kinds of readings associated with excess bearishness.  We'll be watching how impulsively or correctively the wave patterns unfold for strong clues to what is playing out with respect to mid to long term outlook.  Look out for our report next month.

For regular, ongoing commentary on the Elliott Wave trends in all the major markets, be sure to visit our good friends at Elliott Wave International.

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