Investor Sentiment: Intent On Crushing The Bears

There is no meaningful difference in the "Dumb Money" and "Smart Money" indicators from last week. The "dumb money" is extremely bullish, and their persistence is being rewarded as the major indices turned in winning performances for the month of May. The "smart money" is bearish but not to an extreme degree.

As I have pointed out over the past couple of weeks, it takes bulls to make a bull market, and I have not completely resolved the issue of new bull market versus bear market rally. My own work suggests bear market rally, but I do acknowledge that the persistence of the bulls is very reminiscent of 1995 or 2003, when sentiment got stuck in the bullish extreme while prices continued higher. As the equity indexes continue in a range, we haven't seen the "much higher" yet to confirm the new bull market scenario. On the other hand, we haven't seen the market break down and confirm the bear market rally scenario. We are stuck in a range, which means lack of resolution.

The "Dumb Money" indicator is shown in figure 1. The "Dumb Money" indicator looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investor Intelligence; 2) Market Vane; 3) American Association of Individual Investors; and 4) the put call ratio.

Figure 1. "Dumb Money"/ weekly

The "Smart Money" indicator is shown in figure 2. The "smart money" indicator is a composite of the following data: 1) public to specialist short ratio; 2) specialist short to total short ratio; 3) SP100 option traders.

Figure 2. "Smart Money"/ weekly

Other sentiment data that I have available to me presents a mixed picture. According to a research report (dated: May 6, 2009) from Insider Score: "Insider Sentiment: "Sales Widespread, Buyers Show No Conviction". Their key findings were as follows:

1) Market-wide sentiment falls to worst levels since February 2007 as sellers cast wider net.

2) S&P 500 sentiment worst since May 2007; Russell 2000 sentiment worst since December 2006.

3) Technology sentiment worst since November 2006.

4) Insiders using post-earnings trading windows to sell; buyers showing little conviction.

5) CEO and CFO sales increase.

The extremes in insider selling and lack of insider buying are not necessarily harbingers of a market top. As the report explains:

"The last time we saw sentiment this bearish was six weeks before the sub-prime implosion and credit crunch hit." On the other hand, "we should also note that extreme levels of selling haven’t always correlated to market tops as you can see in the chart on the previous page. For example, the highest levels of selling in late 2006 were in the midst of the previous “bull run” and occurred well before the market hit its all time highs."

Another sentiment data point, which shows that the intent of the bulls is to crush the bears, comes from the Rydex asset data. Rydex is a family of mutual funds providing intraday trading, leveraged products, and products inverse to the major indices. Think of Rydex funds as fore bearers to the present day menu of ETF's. Everyday, Rydex provides the actual flow of assets into each fund and one can "see" where money is going - that is, where investors are putting their hard earned cash.

One metric I like to look at is the amount of money in the Rydex bearish and bullish leveraged funds. Investors not only are picking a direction (i.e., bull v. bear) but they are doing so with conviction (i.e., using leverage). A graph of the Rydex bullish leveraged (green line) v. bearish leveraged (red line) is shown in figure 3, a daily chart of the QQQQ. Typically, we want to bet against the consensus. So when there are too many bulls using leverage we should be bearish; too many leveraged bears and we should be bullish.

Figure 3. Rydex Leveraged Bulls v. Bears/ daily

As you can see from the graph, we have had two spikes in the amount of bearish leveraged assets relative to the bullish leveraged assets over the past week. In other words, there were too many leverage bears. The following day prices spiked crushing the bears. The bears are having a difficult time gaining traction. And by extension, one can draw the conclusion that the current rally isn't about true buying demand but the result of short covering.

To summarize, the current price range indicates a lack of resolution. Resolution of the current price range should provide clarity to the following questions: are we in a new bull market or is this a bear market rally? The persistence of the bulls and the lack of bearish traction in the Rydex data is noteworthy. This is the kind of price action that emboldens the bulls and demoralizes the bears and can be self-fulfilling leading to higher prices.

Over the past couple of weeks, I have presented a more bearish scenario that has been at odds with the bullish price action. Within the context of a bear market (which I believe we are still in), excessive bullish sentiment should be interpretated as a reason to expect lower prices. In addition, the trends in inflation sensitive assets are also a significant headwind especially in a bear market. I recognize that I can be wrong; I recognize that my tools may not detect subtle changes in trend. The current bullish price action (or lack of bearish price action) is still within the realm of my studies for me to continue to call the current upswing a bear market rally. Nothing has changed for me to "throw in the towel", but I have discussed, in the May 5th commentary, what would make me change from bear to bull.

5 Reasons To Be Bullish On Gold

Before getting to our analysis, let me first state that I hate snappy titles like the one I have used for this article. You know, "4 Reasons To Be Bullish On Blah, Blah, Blah....". They feel self-promotional and somewhat amateurish to me, and this makes me nervous. I always prefer to be business like in my approach and let the objectivity of my tools (i.e., indicators) do the talking.

Nonetheless, I believe (and have believed for several weeks now) that the current technical dynamic in gold is potentially very bullish, and I believe we are beginning to see confirmation of such a scenario. So in this instance, I will use the headline (as above) because I am told these are the kinds of headlines people like to see!!

The first factor I have been writing about is the launching pad. Figure 1 is a monthly chart of a continuous gold futures contract, and the indicator in the lower panel looks for statistically significant periods of price consolidation (i.e., the launching pad). As we can see, gold is on the proper launching pad to make a sustainable bullish move.

Figure 1. Gold/ monthly

The second factor is the price action. Once again, refer to figure 1. A monthly close above 884 was the first bullish sign (see point 1). The retest came at point 2. The "breakout" is now occurring at 945. This is our new level of support.

The third factor is the price pattern. This can be seen in figure 2, a weekly chart chart of the SPDR Gold Trust (symbol: GLD). The inverse head and shoulders pattern is obvious, and a break out from this pattern should carry prices to the $120 level.

Figure 2. GLD/ weekly

The fourth factor is the US Dollar Index (symbol: $DXY). Our Dollar model was going to give a sell signal at the end of this month, so the pressure of a higher dollar is no longer a headwind for gold. A weekly chart of the Dollar Index is shown in figure 3, and the quasi head and shoulders top is noted. The neck line is at $80.74. As noted previously, it was difficult for me to gauge how fast and how far the Dollar might fall. Today's drubbing may be providing a clue. Nonetheless, a weaker Dollar favors gold.

Figure 3. $DXY/ weekly

The fifth factor is gold's performance relative to a basket of 8 currencies. Those currencies are: 1) Australian Dollar; 2) Canadian Dollar; 3) Swiss Franc; 4) Eurodollar; 5) British Pound; 6) Singaporean Dollar; 7) Japanese Yen; 8) US Dollar. As seen by the indicator in figure 4, gold is now "breaking out" and out performing those currencies.

Figure 4. Gold v. Currencies/ weekly

So let's summarize. Gold is on the launching pad that could carry prices to the $1200 level.

10 Year Treasury Yields: Price Action Confirms Secular Trend Change

A monthly close over 3.432% confirms the secular trend change in the 10 year Treasury bond that I have been expecting and writing about for over 6 months. I am expecting yields pressures to persist for the next 12 months.

Figure 1 is a monthly chart of the yield on the 10 year Treasury bond. The "next big thing" indicator is in the lower panel, and it has been indicating that there is a high likelihood of a secular trend change in Treasury yields. A monthly close over the most recent pivot or resistance level provides confirmation of this secular trend change.

Figure 1. Yield 10 Year Treasury/ monthly

While yield pressures should persist for some time, this won't be a straight line shot to a 5% yield. In the near term, technical considerations should limit the upside to Treasury yields, and over the next couple of months government intervention and the struggling economy will likely remain headwinds.

Figure 2 is a daily chart of the ProShares UltraShort 20+ Year Treasury (symbol: TBT). This is a leveraged ETF product that trades on average 5 million shares per day. Per the ProShare website, TBT "seeks daily investment results, before fees and expenses and interest income earned on cash and financial instruments, that correspond to twice (200%) the inverse (opposite) of the daily performance of the Barclays Capital 20+ Year U.S. Treasury Index." In other words, TBT goes in the direction of yield and in the opposite direction of Treasury bonds. (While I have been focusing on the 10 year Treasury yield, the comments really have been applicable to all yields at the long end of the curve.)

Figure 2. TBT/ daily

Referring to figure 2, point 1 marks the bottom for TBT; the move from point 1 to point 2 led to a healthy 3 month consolidation; the breakout was at point 3. According to the "text book" of technical analysis, the move from point 3 to today's close is a measured move in that it is equal to the point move from point 1 to point 2. In addition, TBT is filling the gap down that occurred back in November, 2008 (see point 4), and there is significant resistance in this area (see oval on the chart). Based upon this analysis, the price action has been bullish for yields, and I would look for TBT to consolidate before heading higher. In other words, yields should back off a bit.

Figure 3 is a graph I have shown before and it is a weekly chart of the yield on the 10 year Treasury bond. The breakout from the down channel is evident.

Figure 3. Yield 10 Year Treasury Bond/ weekly

Lastly, higher yields in the long end of the curve must have the Federal Reserve worried. After all, wasn't quantitative easing -the Fed's "nuclear option" of monetizing debt- suppose to keep yields low so that mortgage rates would be low so that we could either refinance our personal debt and use our homes as an ATM machine circa 2005 or solve the housing crisis by somehow spurring demand. Of course, all of this was going to jump start the economy.

Somehow all of this sounds like treating the drug addicted by prescribing them more morphine. In the end, it doesn't work!

Higher yields will be a drag on the economy and on equities, and this alone will limit their ascent. Thank goodness for normal feedback loops.

But what is normal in a market manipulated by the Federal Reserve? Nonetheless, the next move will be up to the Bernanke Fed. What action, if any, will we see to reign in rates? It is obvious that the current situation is a bit out of control. Will the Fed panic? How drastic will be their interventions? More importantly, what will be the "free" market's response? No doubt the market did not like the first quantitative easing program announced on March 18. Since that day -after the initial knee jerk reaction -the yield on the 10 year Treasury bond has done nothing but move higher.

The Dollar Index And McDonald's Corporation

It is no secret that the Dollar Index (symbol: $DXY) is under pressure as concerns are mounting that the only way out of our debt dilemma is for our government to devalue the currency.

With a monthly close below the simple 10 month moving average, my Dollar trading model is set to give a sell signal. I first went bullish on the Dollar Index back in August, 2008. Although the model is generating a sell signal, the real question that I have on my mind is what kind of downside pressure we shall continue to see in the Dollar Index in the coming months.

First, let's say I would become constructive on the Dollar Index on any monthly close greater than the simple 10 month moving average. However, any gains following such an event would likely be sub-par as the technical and secular winds currently are not in the Dollar's favor. That's the easy part.

The hard part is assessing how fast and how low the Dollar Index can go once we get the current sell signal. Figure 1 is a monthly chart of the Dollar Index, and for "practical" purposes -because everyone will be watching - we can use $80 as our current line in the sand. As I write, the Dollar Index is right at $80. The previous thrust up (labeled with red down arrows) is a lower high, so the move from August, 2008 to May, 2009 appears to be a cyclical rally in an ongoing secular bear market. Based upon this, I would look for a break of $80 and test of the lows at $71.

Figure 1. $DXY/ monthly

A weekly chart of the Dollar Index is shown in figure 2, and this quasi -head and shoulders top is shown. The neck line is at $80.74, and this should continue to provide resistance. A projection of this pattern will take prices to the $71 level.

Figure 2. $DXY/ weekly

While the Dollar Index was getting smacked last week, McDonald's Corporation (symbol: MCD) was bucking the trend of the overall equity market and rocketing higher. MCD was up almost 7% for the week on very little news. There was an analyst upgrade from Deutsche Bank AG citing “compelling valuation” and “attractive” cash flow. Maybe this was his way of saying that McDonald's would benefit from a falling dollar.

As an aside and for newer readers to this blog, McDonald's is a stock I have been following since the beginning of the year when I identified it as "dead money" despite the accolades and cheerleading over at CNBC.

A monthly chart of MCD is shown in figure 3. A monthly close above the pivot low point at $57.93 would be bullish and reverse the bearish trend. A monthly close above $62.19 would be uber-bullish and likely launch MCD on a long bullish trend. MCD has been consolidating in a tight range over the past 18 months and this represents an appropriate launching pad for a bullish run.

Figure 3. MCD/ monthly

Investor Sentiment: A Widening Divergence

For the US equities market, we see a widening divergence between the "Smart Money" and the "Dumb Money" indicators. The "dumb money" has maintained its extreme bullishness from last week while the "smart money" is now more bearish.

The "Dumb Money" indicator is shown in figure 1. The "Dumb Money" indicator looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investor Intelligence; 2) Market Vane; 3) American Association of Individual Investors; and 4) the put call ratio.

Figure 1. "Dumb Money"/ weekly

The "Smart Money" indicator is shown in figure 2. The "smart money" indicator is a composite of the following data: 1) public to specialist short ratio; 2) specialist short to total short ratio; 3) SP100 option traders.

Figure 2. "Smart Money"/ weekly

In general, it is best to bet against the "dumb money" and bet with the "smart money". Of course, there are exceptions to these "rules". As we noted two weeks ago, it takes bulls to make a bull market, so too many bulls, as we see now, could be a good thing. On the other hand, as we noted last week, the 4.9% sell off in the S&P500 two weeks ago was atypical for a bullish trend characterized by too many bulls. In fact, such a downdraft usually portended lower prices.

This week we now have the "Smart Money" indicator becoming less bullish while the "Dumb Money" indicator has maintained a very bullish posture. In a bear market environment, this widening divergence will favor the "smart money". In other words, look for the market to roll over. In a bull market, such a divergence was of no consequence.

It has been my view (since the rally began on March 9, 2009) that this is not the "technical" launching pad for a new bull market. I have summarized this research in the article "Bear Market Rally or New Bull?" So per my methodology, we are still in a bear market, and I am expecting the rally to rollover in the next couple of weeks. In this instance, I want to be betting against the "dumb money" and betting with the "smart money". In addition, I think that this notion of too many bulls as a sign of new bull market will be wrong in this case as last week's data point suggests. To go higher the market will need to go lower first. More bulls need to be converted to bears.

If wrong in my assessment, I discussed where and when I would throw in the towel and jump on the bullish bandwagon. As I wrote on May 5:

I am well aware that a bull market can start without my criteria being met. The market seems to have a way of spoiling the best of plans. So I still must be prepared for the possibility that my indicators and tools just aren't sensitive enough to detect a new bull market.

If this turns out to be the case, then I would "throw in the towel" if the S&P500 closed above its simple 10 month moving average on an end of month closing basis. Mebane Faber, from the World Beta Blog, has presented a very simple (yet effective) timing system that utilizes the simple 10 month moving average. If the S&P500 were to keep rising and print a monthly close above its simple 10 month moving average, then I would call this a new bull market. I will also point out that no major index has yet to end the month above its simple 10 month moving average.

Until then, I still believe we are in a bear market. Until my indicators give the signal, I still don't believe the potential for a new bull market exists. The possibility of a new bull market is always present, but the probability at this point in time seems rather remote.

Inflation Expectations To Pressure Equities

This is a headwind for equities that has started to pop up over the past couple of weeks. Yet, it has taken years to ferment and likely will persist for the foreseeable future. The headwind I am talking about is inflation.

Inflationary pressures -whether real or perceived - will likely remain high, and this can be seen in our inflation indicator that looks at the trends in crude oil, gold, and yields on the 10 year Treasury. See figure 1, a weekly chart of the S&P500 with our inflation indicator in the lower panel. With strength this past week in crude oil, gold, and yields, the indicator is back in the extreme "high inflation" zone.

Figure 1. SP500 v. Inflationary Pressures

As discussed in the article "More Headwinds To Worry About", inflationary pressures are a significant headwind for equities even in the bull market of the 1980's and 1990's. This should be clear from the study presented in that article. When the trends in crude oil, gold, and yields on the 10 year Treasury are strong and rising, equities tend to under perform.

Gold: Still On The Launching Pad

I last wrote about gold on April 30, 2009. In that article, I stated that gold was on the launching pad. Something big was going to happen. Gold had consolidated into a range that would lead to a breakout or a breakdown. The only problem I had no idea what direction gold was going.

To my credit, I did suggest going long at that time as gold was at support and this represented a low risk buying opportunity. But truth be told, I really had no clue or inclination that gold would be up 5% over the next month.

So let's review the technical picture and discuss some possible factors that could propel gold higher.

Figure 1 is a monthly chart of a continuous gold futures contract. Gold still remains within a very narrow range between support at 884 and resistance at 945. It is currently at the upper end of that range. This consolidation is our launching pad. A monthly close above 945 is the "breakout" that would make gold bugs happy.

Figure 1. Gold/ monthly

Figure 2 is a monthly chart of the SPDR Gold Trust (symbol: GLD). Our levels are shown, and a monthly close over 92.63 would be considered bullish.

Figure 2. GLD/ monthly

Figure 3 is a weekly chart of the GLD, and the range is noted with the upper end being at $95. This coincides with a down sloping trend line as well. For you "head and shoulder" buffs, the inverse pattern is obvious, and a breakout of the neck line at $95 would likely propel prices to $120.

Figure 3. GLD/ weekly

But let me reiterate that gold still remains in a range, and this can be easily seen in the next graph (figure 4), which is a weekly chart of a continuous gold futures contract. The indicator in the lower panel compares gold's performance to a basket of 8 currencies. The currencies that I am looking at are: 1) Australian Dollar; 2) Canadian Dollar; 3) Swiss Franc; 4) Eurodollar; 5) British Pound; 6) Singaporean Dollar; 7) Japanese Yen; 8) US Dollar. The indicator, which should lead the price action, remains range bound - like the price of gold.

Figure 4. Gold v. Currencies/ weekly

The fundamentals for gold are easiest explained by the competing forces of inflation and deflation. The ultra easy monetary policies of central bankers are today's seeds that are sowing tomorrow's inflation. Stock market weakness, which I have been expecting for several weeks now, will likely bring about another round of "alphabet soup" programs from the Fed and Treasury. The expectation is that the government will do whatever it takes to prop up asset prices. Under such a scenario, gold will act as a safe haven during stock market weakness, and there is little doubt that stock market weakness and expected government interventions will fuel inflationary expectations. These are the tailwinds that might propel gold higher. On the other hand, the global recession isn't over, and deflation still remains a threat. Although the technical picture appears favorable, gold remains range bound, which I believe reflects the current fundamental dynamics.

Barron's Weighs In On Treasury Yields (Again!)

This is the second cover story in 5 months for Barron's on the bursting of the bubble in Treasury yields. I have been closely following the yield on the 10 year Treasury since December, 2008, and I would agree that Treasury yields are ripe for a secular trend change. However, this won't be confirmed until there is a monthly close over 3.43% in yield.

In this brief video, Barron's editor, Andrew Bary, states that yields could "rise even more hitting 5% by year end as investors need to absorb the massive amount of debt that government is issuing to fund record budget deficits."

The three main headwinds to the scenario of higher Treasury yields remain: 1) continued economic weakness; 2) continued quantitative easing by the Federal Reserve; 3) continued and persistent bubble bursting "calls" by everyone concerned.

On the other hand, the technical set up for higher yields is compelling, and as Mr. Bary alludes to, investors are demanding higher yields to the increasing supply of debt.

Headwinds

Figures 1 and 2 are monthly charts showing the composite yield on the long term Treasury bond. The indicator in the lower panel is an analogue representation of the National Bureau of Economic Research's (NBER) expansions and contractions. The NBER is the government organization that officiates over the beginning and ending times of a recession. On the graph, the gray vertical bars highlight recessions. The vertical gray bars indicate periods of economic contraction (i.e., recessions). The relationship between Treasury yields and economic contractions is easily seen. It would be highly unusual for yields to rise during a recession.

Figure 1. Long Term Treasury Yields v. NBER Contractions

Figure 2. Long Term Treasury Yields v. NBER Contractions

The pace of economic decline has slowed lately, but there seems to be little consensus on what happens next. Lakshman Achuthan of the Economic Cycle Research Institute sees "Crystal Clear Recovery Signs" by this summer, and that "call" is presented in the following video from Bloomberg. On the other hand, former Merrill analyst, David Rosenberg, had this to say about Treasuries:

"Even if the recession is to end soon, and that is still very debatable, bond yields do not typically bottom until we are well into the next cycle, as inflation continues to decline even after the downturn ends. So just like further upside potential in equity prices seems extremely unlikely over the near and intermediate term, further downside risk Treasury note and bond prices is also less of a risk today, in our view."

And Rosenberg is correct, higher Treasury yields typically are not seen well into an economic expansion. This can be seen in figures 3 and 4, which are just like the figures above but now I have added a dashed vertical to the graphs indicating when yields traded meaningfully higher and above the simple 10 month moving average. "Typically" higher Treasury yields occur well into a recovery.

Figure 3. Long Term Treasury Yields v. NBER Contractions

Figure 4. Long Term Treasury Yields v. NBER Contractions

I guess the last word between economic growth and Treasury yields goes to the Federal Reserve in this article on Bloomberg: "Fed Views Jump in Yields as Sign of Better Outlook". Higher yields are in juxtaposition as to what the Fed would like to see. Nonetheless, it is their belief that higher yields are the result of improving economic conditions.

Another headwind for higher Treasury yields has to be quantitative easing, which is the Fed's plan, announced March 18, to buy $300 billion of long term Treasury debt. The Fed has bought $100 billion so far, and the option is always on the table to buy more. According to Stuart Spodek , co-head of U.S. bonds in New York at BlackRock:

“The Fed needs to consider increasing its purchases of Treasuries. We are still in a recession. It’s quite bad. They need to stabilize long-term rates.”

It should be noted that despite the medling in the market by the Fed, 10 year Treasury yields are higher than the day the program was announced.

The last major headwind for higher Treasury yields has to do with sentiment. Everyone is looking for a bubble in Treasury yields. It is right there on Barron's cover. Two weeks ago it was part of the Bob Pisani's Investing 101.

Everyone now knows that Treasury bonds are a bad investment and this is rarely a recipe that leads to a secular trend change. Think back to the major trend changes of the past year. Crude oil topped out amid "calls" of $200 oil. The US Dollar Index bottomed amid "calls" for the crashing dollar. Markets rarely reverse when everyone expects them too.

Tailwinds

As I have been stating since December, 2008, the technical outlook is such that a secular trend change is in the cards for Treasury yields. We will see higher yields and it isn't a matter of if we will but when we will. The secular trend for higher yields on the 10 year Treasury bond will be confirmed on a monthly close greater than 3.43%, and it is my belief that this will happen by the end of the third quarter of this year.

Will higher yields be the result of increasing economic activity as some are suggesting or as this week's Barron's article suggests there is an excess of government bonds coming to market, and investors are demanding higher yields?

Of course, we will see how this plays out over the next couple of months. The markets (equity and bond) are at another one of those critical junctures. So let's give the last word to CNBC's Rick Santelli who always seem to provide some good perspective of the broader playing field.