A Seductive Scenario

Jay Shartsis doesn’t write poetry… but he does craft some
very seductive prose. Jay doesn’t pen verses about love or
romance, but he does issue trading alerts that examines the
fleeting passions of investors. Specifically, he examines a
wide range of sentiment indicators to gauge the stock
market’s likely future course.

In the days preceding yesterday’s rally, Shartsis had been
warning his clients of an extreme "oversold" conditioned in
the U.S. stock market. Based on his observations, the savvy
options trader for R. F. Lafferty in New York had devised a
"working scenario" in which stocks bounce very forcefully
for several days, before ultimately exhausting themselves
and "rolling over" to new multi-month lows.

Jay based this scenario primarily on the fact that option-
buyers had become a bit too bearish, which, as a contrary
indicator, suggested that stock prices would advance. "The
market is heading toward a ‘tradable low,’" Jay predicted
late last week. "Some put/call gauges are showing high
levels of pessimism, as the air but looks like the final
stages of a decline."

Jay pointed out that option traders were increasing their
bearish bets against the market. In particular, he noted
that small investors (those who purchase less than 10
contracts at one time) had become conspicuously aggressive
put-buyers. This group of traditionally "dumb money" often
bets against the market at exactly the wrong time.

"It is probable that the market is approaching a tradable
low," Shartsis reiterated late last week. "Several put/call
gauges show a pretty high level of pessimism, but they
allow for a further downside spike to get them into extreme
territory. Perhaps the best strategy now is to get ready to
go long, but not unless the market puts in a solid reversal
day. A solid reversal day requires a lower morning –
perhaps sharply so – and a reversal back up late in the
session with a strong close on heavy volume. If that does
not appear, I would stay away because he could get quite
ugly fast."

Monday morning, Jay fired off a fresh missive to his
clients in which he continued to alert them to the
possibility of an imminent rally. "As anticipated," Jay
reported, "the market continues to slide deeper into
oversold territory…The NYSE oscillator of Larry McMillan
(editor of the market letter, McMillan Analysis) is below –
600, ‘very rare territory,’ as he calls it, and he notes
that the last three times this phenomenon occurred were May
2004, October 2002 and July 2002. All three instances
marked major bottoms, followed by strong rallies. McMillan
remains cautious but is allowing for a sharp, short-lived
rally. Which sounds right to me."

Shartsis also observed bullish signals emanating from two
other sentiment gauges he monitors. First of all, the
plummeting NYSE advance/decline readings of recent days
suggested to him that the market had reached an important
"selling climax." Five out of the prior eight trading days
had recorded sessions in which at least 1000 more stocks
fell than advanced. As a result, the 15-day average of the
NYSE advance/decline line get to an oversold level that has
produced 30-day rallies in 37 of 38 prior occurrences.

"Also suggesting that a market bottom is approaching," said
Jay, "is the ISE Sentiment Index, which last week dropped
to 119 (i.e., 119 calls purchased for every 100 puts
purchased), which is the most put-buying since last October
14th, immediately before the start of the day to year-end
rally."

Your editor checked in with Jay yesterday to see if he had
altered his outlook in any way.

"Not really," came the reply. "Investors are exhibiting the
sort of extreme pessimism that often precedes tradable
rallies."

"You said you were waiting for a ‘big reversal day’ to
signal the start of a new rally. Does today’s big up day
satisfy you?" we asked. "Since it follows so close on the
heels of Tuesday’s sell-off, does this qualify as the
reversal day you were anticipating?"

"Well it wasn’t exactly the type of reversal I was looking
for," he replied, "but it might have to do. I feel pretty
sure this rally will last long enough to bring a few smiles
to Wall Street. But I’d caution against falling in love
with it. You’ll want to trade this rally for a good time,
but not for a long time."

"Why’s that?" we asked.

"Because longer-term sentiment indicators tell a very
different tale. The CFTC Commitment of Traders report lurks
in the background like the grim reaper."

Shartsis was referring to the final phase of his scenario –
the looming sell-off after the rally. "After the market has
a rally to relieve the current oversold condition," he
wrote to his clients earlier this week, "a first-rate
problem for the bulls is the position of the ‘large
speculators,’ thought to be mainly hedge funds, that own
Dow futures contracts. They are often wrong and are now net
long a record 14,196 contracts. The last time they were
heavily net long was in February 2001, when they were net
long 7,407 contracts, and the Dow cratered 17% in only a
month a half into mid-March 2001. Particularly worrisome
now is that their position is nearly twice as large as in
2001, and that looks pretty ominous."

Jay Shartsis may not know an iamb from a dactyl, but he
does know a thing or two about the cadence of financial
markets. So we should not be surprised if U.S. stock market
rallies for a while, before returning to its losing ways.

Did You Notice…?
By Eric J. Fry

It has become somewhat chic to deride the bull market in
energy stocks as a "mini-bubble." We don’t agree. Perhaps
the energy bubble is so mini that it is invisible to the
naked eye, or perhaps it is concave. This "bubble"
currently sells for about 13 times TRAILING earnings, while
the rest of the stock market – that portion which resides
outside the energy bubble – sells for more than 20 times
earnings.

When dealing in the context of recent financial market
history, the bubble accusation seems even more ludicrous.
As the nearby chart illustrates, the weighting of energy
stocks within the S&P 500 has fluctuated over the last
decade, but has not increased one iota since 1995.
Meanwhile, financial stocks have greatly increased their
presentation in the S&P 500 over the same time frame.

Back in 1980, financial stocks and energy stocks possessed
the exact opposite weightings in the S&P 500 that they do
today. Energy accounted for about one-quarter of the index
while financial stocks accounted for less than 10%. We all
know what happened next: financial stocks soared for the
next two decades, while energy stocks languished.

Today, however, the opposite situation abides. But we did
not expect it to abide for much longer. In a world of
rising energy prices and rising interest rates, we would
expect oil stocks to steal S&P 500 "market share" from the
financial stocks, in which case the mini-bubble that some
investors find so troubling to become much, much bigger
before it eventually bursts.

"The assets on the balance sheets of energy companies are a
lot more tangible, and in a globalized world, a lot more
valuable than say, a pool of mortgages," observes Dan
Denning, the mind behind the Strategic Options Alert.
"Pools of oil versus pools of mortgages. You make the
call."

Strategic Options Alert

And the Markets…