How Skepticism Can Fuel a Rise

Terrific article in today’s WSJ by E.S. Browning on how disbelief in a market move can actually be a cause of that move going even further:

"The doubters, of course, could be right, and you would think that all this skepticism would be bad for stocks. If a lot of smart people don’t believe in the rally, how can that be good?

That’s where the irony comes in. Stock rallies often happen when the market is full of doubters. Those are times when money managers and individuals alike have pulled money out of stocks and are holding cash, bonds or other investments. If the market begins to turn up, these people start to feel left behind. They have money available to shift into stocks, and they do so.

As long as doubters remain to be converted, money can keep moving away from other investments and into stocks, pushing prices higher."

How does that change once the sentiment begins to shift to excessively bullish?

"Once the great majority is bullish, however, things are different. Froth appears, as it did during the 1990s. Instead of holding money on the sidelines, people borrow against their homes or from their brokers in order to invest. That is when stocks can be at risk, because there is little free money left on the sidelines to move into stocks.

What interests some analysts is that the market still doesn’t seem frothy, even though the Dow Jones Industrial Average is up 14.9% since July 14 and has racked up 18 record finishes since October began, and even though the Nasdaq Composite Index is up 21% since July 21 and near a six-year high."

The column also quotes a who’s who of technical and quant luminaries:

-Paul Desmond, president of research service Lowry’s Reports
-Ned Davis, founder of Ned Davis Research
-Louise Yamada, former head of technical research at Citigroup’s brokerage arm
-Phil Roth, chief technical market analyst at New York brokerage firm Miller Tabak.

The article specifically notes "Bearish investors — short sellers — are throwing in the towel. These are people who borrow stock and sell it in the expectation that they can profit by buying it cheaper later. After all the gains, they are "covering" their bets by buying the stocks back, often at a financial loss." That short covering is part of the fuel for the move higher.

Investor pessimism over the summer has morphed to a more optimistic outlook of late. And, the column notes, "indicators still aren’t showing excessive optimism."

That contrary indicator, plus the overall market momentum, has been
why I have been steadfast against shorting this market since the June lows. Investors should
never step in front of a locomotive, and must always wait for a
technical signal prior to going short on a macro basis.

Paul Desmond added:

"We keep getting calls, especially from our older clients, saying, ‘I am deathly afraid of waking up and getting a 30% decline.’ We are telling them that we think there will be plenty of warning signs before something like that happens."

Investors need to be patient, waiting for those signs . . .

How Skepticism Can Fuel a Rise
A Rally Too Good to Believe Also Has Cash Waiting to Enter;
Acute Optimism Is What to Fear

WSJ, November 20, 2006; Page C1

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  1. ilsm commented on Nov 20

    There is so much money laying around, gotta go somewhere.

  2. jmf commented on Nov 20

    maybe a little bit ot but worth reading. also some really great charts.

    Profit Margins, Earnings Growth, and Stock Returns
    Investors consistently overpay for stocks in periods when profit margins are high (hussman)

  3. JGarcia commented on Nov 20

    <> (to short??)

    …or you can buy good quality, liquid names that are a clear bull mode (nice relative strength).

    Today’s buyouts are not a sign of weakening demand for equities. The market smells too much negativity on the economy, lots of liquidity, and a Fed that’s done pushing us back.

  4. blam commented on Nov 20

    Interesting article – Kitco Base metals

    The Coming Nuclear Winter in Base Metals – by Frank Veneroso , Nov 17 2006 3:56PM

    Veneroso has been wrong about the metals collapse since 2005. However, the degree of market manipulation has been unprecedented.

  5. Bear Mountain Bull commented on Nov 20

    Wall of Worry

    At The Big Picture this morning, Barry Ritholtz has a good post centered around a WSJ article on skepticism in the market, and how that sentiment can help to keep a rally going – that proverbial wall of worry that the market is said to cl…

  6. Mike B commented on Nov 20

    Interesting, this is a common theme I hear a lot of lately:

    ‘Paul Desmond added:

    “We keep getting calls, especially from our older clients, saying, ‘I am deathly afraid of waking up and getting a 30% decline.’ We are telling them that we think there will be plenty of warning signs before something like that happens.”

    Investors need to be patient, waiting for those signs . . . ‘

    Who is to say this couldn’t happen? With so many people waiting for signs of a top before pulling out, it is quite possible a topping event could surprise everyone and cause a drastic downday. I know it is unlikely, but it is possible especially with the way everyone is positioned long until proven otherwise.

  7. Macro Man commented on Nov 20

    In the futures market, at least, long positions are relatively modest (click name for link to charts.) At this point, the primary plank in the bear argument has got to rest on a collapse in earnings growth (or indeed earnings full stop.) At this stage, it is premature to call that a done deal.

  8. lurker commented on Nov 20

    But doesn’t anyone else get spooked when the WSJ says don’t worry stay bullish and wait until the fat lady clears her throat before running for the exits? Spooks the heck out of me. Particulary when “everyone” knows we are in the most bullish time of the year and stocks go up until April. Gives me the willies.

  9. Michael C. commented on Nov 20

    Let’s see if we can plunge that Vix into single digits this week.

    I think we’ll get some good action next week after Black Friday shopping stats are revealed.

    I am seeing promotions galore everywhere and the glitziest catalogs I have ever seen. But I’m not sure what that portends.

  10. Philippe RAFAT commented on Nov 20

    When investors look for capital gains as opposed to dividend yields existing or future (next year for instance), when merger and acquisition are paid in stocks for value enhancement,when insiders start selling in flock,when projects are sold on future capital appreciation as opposed to cash flows seem the better days to leave the “table” rather than waiting for the “distribution days”.

  11. Michael C. commented on Nov 20

    It seems interesting that there is so much M&A activity and private equity money when insiders are selling at such high levels as well.

  12. HS commented on Nov 20

    Does anyone know what Lowery reports was saying last May? hmmmm….

  13. Michael C. commented on Nov 20

    We tag 9.99 on the Vix!

    …not that that means anything…

    Forget Black Friday. Just login to your stock accounts and buy buy buy. Valuations are so cheap it’s like we are at the outlets with store coupons and on top of all all that frequent flier mileage when we charge it up the wazoo.

  14. Jason M commented on Nov 20

    Barry, why don’t you cut the suspense and tell us what these magical warning signs will be right before the crash? Just in case I don’t happen to be reading your blog the day before…

    On that note, I’ve been a regular reader of this site for many weeks and certainly haven’t heard a drumbeat of “don’t short this market.” If that’s your position you should be a little more vocal about it given your overall opinion of the economy.

    Otherwise it sounds like you are just covering your a**.

  15. Michael C. commented on Nov 20

    IMO, we are in an extremely difficult time in the market.

    Everyone is more anxious to perform than ever, but risk has never been higher.

    So either plug your nose and buy, or wait and watch this momentum driven market.

    Neither is pleasant, but only one may be prudent.

    Jason M – What do you expect? Blatant price and news predictions everyday? I don’t remember this blog ever being about that.

    I have a better idea. Why don’t you just ignore everything you’ve read here, hit that buy button and start making easy money. You know you want to. That way we can get to the top that much sooner.

  16. Kevin Duffy commented on Nov 20

    1) Most sentiment polls are at or near bullish extremes:

    – AAII: 46.6% bulls = 63rd percentile of bullishness (based on past 10 years of data). This is a notoriously volatile series. The week before reading was 50.6% (73rd percentile)
    – Investors Intelligence: +34.1% bulls – bears = 88th percentile of bullishness
    – Consensus Inc.: 68% bulls = 89th percentile. Previous week reading was 74% (93rd percentile)
    – Market Vane survey of futures advisers (not mentioned): 73% bulls = 99th percentile

    2) Short sellers are nearly extinct. Perhaps the comment “short selling on the New York Stock Exchange shows that the practice remains widespread” refers to a record high short interest ratio. These data are hopelessly distorted by arbitrage activity. This indicator hit record highs in 2000 – right at the top of the tech bubble – and was trotted out by the bulls as another excuse to stay long. There are currently just $4 billion in bear mutual funds against $5.5 trillion in total stock mutual funds. The number of hedge funds in the Strunk Short Sellers Index has shrunk from 25 to 8 or 9.

    3) The notion that there is a mountain of cash on the sidelines is pure fantasy. Back in the late 1970s and early 1980s, 70% of all mutual fund assets were in money market funds. Today that level is slightly over 20% (actually 21.3%, or 99th percentile of bullishness). And the public’s hired guns are fully invested: mutual fund cash levels are currently 4.3% (74th percentile of bullishness) versus over 10% at the ’74, ’82, and ’90 bottoms.

    (Keep in mind, these percentiles were from a data sample of the past 10 years, itself a time of overall optimism.)

    Many bulls actually believe there is a “wall of worry” to support them. This is classic “double contrary” behavior, the kind of delusion that is not uncommon at major tops. (It is also a sign these bulls need professional help.)

  17. sam commented on Nov 20

    when market sells off, oftentimes we hear that we need a massive sell-off for reversal (for a buying opportunity)
    In bull market, what is the equivalent scenario? Massive surge for reversal and then buy puts? (doesn’t ring true? why)

  18. Rick R commented on Nov 20

    For those who follow volatility, the VIX and VXO(OEX Vol#) today hit their lowest readings in nearly THIRTEEN years. When this low was last hit in late 1993, the market had been rallying, and continued up another 3+% into Feb 1994. It then dropped 10+% in the next two months; rest of ’94 was choppy. Good 1995 followed, however.

    Extremely low volatility presages a very steep downdraft, just not at this very moment. Usually not a great time to start loading up on equities.

  19. John commented on Nov 20

    Warnings of a market reversal??… Man I heard all this stuff before when I was on a trading desk back in 1999 / 2000…. The only thing that has changed are the dates…. People have VERY short memories.

    The reverseal will come out of the blue and catch ALL the bulls off guard just like it did back then…. Even back in 2000… as the markets began falling like a knife, the bullish pundits were still telling everyone to buy, buy, buy until it got so embarassing for them, they slithered back into the woodwork. Only recently have they dusted off these asset gathering perma-bulls and paraded in front of the cameras again… you know the ones – Batapaglia’s, Abbey Joseph Cottentop… When you see these guys in front of the camera…. watch out below.

    Retail is jumping in now…. what a great indicator of a top…. The public is always the last one to the party.

  20. whipsaw commented on Nov 20

    per Rick R:
    “For those who follow volatility, the VIX and VXO(OEX Vol#) today hit their lowest readings in nearly THIRTEEN years.”

    Yeah, today Larry McMillan suggested that buying some VIX calls “couldn’t be a terrible thing” so I took a look (after-hours so I just have the last prices, not bid/ask). Jan10 is at 2.50, Feb10 is at 3.20; TWS models say that they should be priced at 1.34 and 1.73, respectively, so they look pretty damn expensive to me.

    What’s interesting is that the last price for all of the 10 puts (which could be somewhat stale) out to May is $.10 with deltas of between .36 and .45. The models suggest that the prices should be between $.80 and $2.30, so it appears to me that the better play would be to buy a boatload of VIX May10 puts with the expectation that if it drops to ~9.80 you could pull out a 50% gain (i.e., they should sell for $.15).

    I recognize that this would be rather remarkable, but it seems to me that I’ve read somewhere that VIX has gotten below 9 before and there is obviously something “unusual” going on at the moment which makes me think that this just might work. The risk is minimal from a trade sizing standpoint, the trade is with the trend, and there is a lot of potential reward at least on paper.

    So I’ll don my flamesuit and invite any comments about the merits of this scheme with the understanding that even while buying May puts I am looking at it as a 2-4 week trade.

    Flame away. :)

  21. scorpio commented on Nov 20

    we are in uncharted territory. when central banks like FRB no longer publish money-supply #s, and UK central bank says it’s got to raise rates to 5% BECAUSE ITS UNDERLYING MONEY SUPPLY IS GROWING 15% then there’s no telling how this ends. i think the banks have completely lost control of the monetary system.

  22. Rick R commented on Nov 21

    Regarding my comment on the VIX and VXO: this usually means a drop is coming….but maybe not for a month or two. It only shows that investors are complacent, ignoring things that would normally prevent them from adding to positions at high levels.

    Historically, there usually is a lag time between the VIX low and the market changing directions. That is probably why option prices have not factored this in, as of yet.

  23. Bill a.k.a. NO DooDahs commented on Nov 21

    VIX is low because actual volatility in the market (defined by average true range in relation to closing price) is low, and because returns have been consistent and good. VIX rises in response to recent activity, i.e. if the market collapses the VIX will go up, usually just in time for the market to bounce, or VIX goes up if the index starts moving in a disorderly fashion. VIX has little predictive power of its own.

    Barry, I just scanned the archives for June and July and I didn’t see which post you made where you were steadfast against shorting this market. I did see several posts that struck me as bearish, and you did post a link to “return of the bear” as well. Could you point out which posts you made that were anti-shorting and/or positive on the market direction soon after the June lows?

  24. henrietta commented on Nov 22

    Great post! That’s the thing, not everyone is convinced of this rally and everyone is looking for a correction. Yesterday I noticed the VIX dropped below 10, next minute, I realized that the world trading community is talking about it. So.. the market tends to always do the opposite!


  25. zentrader commented on Nov 24

    why is it that investors should be patiently waiting to go short? I would suggest that they should instead be looking for opportunities to go long on a short-term pullback.

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