Markets Shun Bearish Sentiment...For Now

During yesterday’s trading session, the stock markets of the world served up something a little different from what has become “standard fare.” The markets served up losses – large ones in China, biggish ones in Europe and noticeable ones in the Americas. The Dow Jones Industrials slumped 112 points, which was only about half as bad as its worst losses of the day.

Taking a slightly longer time frame into consideration, the Dow is zero for the last eight trading days…and not very far from zero for 2010. Most European markets are in negative territory for the New Year, as is the Chinese stock market.

So what gives? Do these disappointing performances point to a bad moon on the rise? Is the great big rally that ignited last March about to extinguish itself?

“Probably,” is the answer provided by Jay Shartsis, Director of Options Trading at R. F. Lafferty in New York.

Jay begins his bearish analysis by pointing out that the world-leading Chinese stock market is now leading to the downside. “The important emerging markets of China , Russia and Brazil have topped out already and have been trending lower,” he observes. “They have leading tendencies to our market, having bottomed out before ours did last March. The chart below shows that Chinese stocks (as represented by FXI, an ETF that holds Chinese stocks) [have] traced out a head and shoulder top, and is now rolling over to the downside.”

Chinese Stocks vs. S&P

Corroborating this negative indicator, Jay cites a wide range of market phenomena that suggest the stock market is more likely to head south than north.

“The bearish percentage of respondents from Investors Intelligence was reported at 15.6% bears,” Jay observed recently. “That was the lowest since April of 1987 when 14.6% bears was reported. After that low reading in 1987, the market dropped about 9% into a late May bottom, then proceeded up to its famous peak of Aug 1987.

“Furthermore,” he continues, “the 21 day market-wide dollar weighted put/call ratio is now flashing bright red. At the Grand Stock Market Top recorded in Oct 2007, the gauge reflected only 58 cents traded in puts for every $1.00 in calls. That was a lot of option trader optimism. And now? A few days ago, this gauge reached 50 cents in puts for every $1.00 in calls – even more optimism than that seen in 2007! This extreme optimism seems even more worrisome, given the fact that stock prices are well below the peaks seen in the fall of 2007. I would rate this as a serious sell signal. Get out of the way.”

Jay’s bearish prognostications attract almost no sympathy on Wall Street where bullish outlooks reign supreme. But far, far away…up above the Canadian border, another market observer voices similar concerns.

David A. Rosenberg, Chief Economist and Strategist of Gluskin Sheff & Associates in Canada, fears that the US stock market is looking toppy. He notes the following:

  • According to Investors Intelligence, there are now three times as many bulls as there are bears. Almost everyone is a performance chaser.
  • Market Vane sentiment on equities has firmed to 57%, higher than it was in September 2007 when the market was beginning to crest. We didn’t see a number of the strong in the last cycle until September 2003 when the recession was already two years behind us. By way of comparison, at the March lows, it was sitting at 32.
  • Not one of the 12 seers polled by Bloomberg sees a down-market for 2010. The median increase in the S&P 500 is 11%.
  • The VIX index is down to 19, right where it was when the market peaked back in October 2007.
  • The S&P 500 dividend yield is back below 2% for the first time in over two years.
  • Corporate bond spreads and CDS credit default swaps have collapsed to levels not seen since two years ago.
  • Based on the Shiller normalized PE ratio, which is based on the 10-year trend in real corporate earnings, the S&P 500 is trading with a 20x multiple versus the long-run average (back to 1881) of 16x. This market, in other words, is more overvalued now (25%) than it was heading into October 1987… Investors should be aware that at this stage, they are buying into a very expensive market…

Steve Sarnoff, editor of Options Hotline, agrees with Shartsis and Rosenberg. He wonders aloud: “Can gravity pull the big stock market rally, from March of 2009, back toward earth? I think it can. Late last year, gold and the euro began to slip. As we move into a new year, I think stocks will join them. Bullish sentiment is reaching extremes, my contrarian alarms are ringing, and the character of market price movement is turning negative. The market is reaching resistance and looks toppy.”

So what should we investors do with the worrisome observations of Messrs. Shartsis, Rosenberg and Sarnoff? Maybe nothing. After all, the markets go up and the markets go down. And no one ever knows what will happen next.

But here’s the problem: the markets just went up…a LOT…even though the economy did not. So maybe the markets will go down a lot, just to reunite themselves with the lackluster economy they left behind.

In such a circumstance, selling a few shares of stock now would not have been such a bad idea.

The Daily Reckoning