What's next for stocks?

Eric Fry - Tue 05 Dec, 2006

...Stocks have generally been going up for many months. Thats probably the very best reason why they might soon go down...

 
 
- Stocks have generally been going up for many months. That’s probably the very best reason why they might soon go down. If, for example, the Dow clings to its positive performance for November, the venerable index would have registered six straight winning months. Maybe it’s time for a losing month.

- Forget PEs ratios; forget "dividend-discount models;" forget productivity gains; forget "Goldilocks" economies. The stock market doesn’t care about these things. The stock market goes up when it feels like it. And it falls when it feels like it.

- Over long-term timeframes, of course, things like earnings and interest rates exercise a great deal of influence over stock market valuations. But over the short-term, PEOPLE influence valuations...not DATA. The collective attitude of investors determines share price levels.

- To anticipate short-term market action, therefore, it sometimes pays to monitor the collective attitudes of investors. When they are feeling extremely pessimistic, stock market rallies often begin. And when they are feeling supremely confident and complacent, share prices tend to fall. At least, that’s the bedrock assumption that inspires "contrarian investing."

- At the moment, investors are feeling extremely confident...maybe too confident. In fact, Jay Shartsis, a seasoned professional options trader and astute stock market observer, suspects investor sentiment has become too bullish for the market’s good.

- "When the United States declared war on Japan after the Pearl Harbour attack," Jay remarked last week, "the vote in Congress was unanimous, except for one member, who thought that in a democracy, it would not be proper for all to vote in favour of war. I don’t recall the name of the representative but I bet she (I think it was a she) would be bearish on the market now. Bullish sentiment is absolutely unanimous."

- "But the bears on the stock market hold more evidence in their favour than the dissenting Congresswoman of 1941," Jay asserted. "For example, on November 17, with the Dow at 12,342 there were 163 new highs on the NYSE.

- By comparison, on October 26th with the Dow at 12,163 there were 431 new highs. That’s a quite sharp contraction of new highs with the Dow nearly 200 points higher. A good piece of bearish evidence."

- Interestingly, the extreme low readings of the VIX Index corroborate this "bearish evidence." The VIX Index, as regular readers may recall, measures the implied volatilities of various options on the S&P 500 Index.

- Because the VIX is based on real-time option prices, it reflects investors' consensus view of future expected stock market volatility. "During periods of financial stress, which are often accompanied by steep market declines," the CBOE Website explains, "option prices - and VIX - tend to rise. The greater the fear, the higher the VIX level. As investor fear subsides, option prices tend to decline, which in turn causes VIX to decline."

- The fact that the VIX is languishing on 13-year lows, therefore, suggests that investors have become overly confident and complacent.

- Put/call ratios tell a similar tale. "The 21-day volume-based put/call ratio for the broad market has dropped to just about where it was at the market top of early last May," Jay observed recently. "It is now at 66 puts traded for every 100 calls and then it was at 65.

- "Imagine, it took a 15 % straight up move to bring this about. Now the bears (if there are any left) are armed with something a lot more potent then the pea shooters they have been using."

- Lastly, Jay notes that the Dow has soared 1000 points above its 200-day moving average. "That is an all-time record," he says. "Joe Granville, who pointed this out, calls it a 'major warning and a sell signal unto itself.' This is hard to ignore."

- The Dow is up 14% for the year. Fourteen percent is not too shabby. So why not call it a year and take December off?


Regards,

Eric Fry
for The Daily Reckoning