Springtime on Wall Street

Springtime has finally arrived on the island of
Manhattan…and the signs of its arrival are abundant.

The indigenous fauna have emerged from their lairs to
saunter along the sidewalks of the city. A few of the most
exotic species have shed their winter coats almost
entirely, as if relying only on the sun’s warmth to
maintain their body heat. The local floral have also
emerged from a long winter of dormancy…Daffodils and
crocuses seem to blanket every park on our little island.

Yes indeed, it is a delightful time of year…

Down here on Wall Street, meanwhile, the signs of spring
are somewhat less evident. Even so, a stock market rally
seems to be budding. This sporadic bloomer does not always
germinate, but the early indications seem quite promising
this year…

We first mentioned the probability of a springtime rally in
the March 31 edition of the Rude Awakening, entitled, "A
Seductive Scenario."

Option-buyers had become a bit too bearish, we observed,
which, as a contrary indicator, suggested that stock prices
might soon advance. "The market is heading toward a
‘tradable low,’" options pro Jay Shartsis predicted at the
time. "Some put/call gauges are showing high levels of
pessimism, as we near what looks like the final stages of a

The Dow has dipped about half a percent since then, thereby
making us neither geniuses nor complete fools. Meanwhile,
the evidence for an imminent rally continues to mount.

Let’s consider the signs:

First up, put-buying is still on the rise, especially among
the out-of-favor Nasdaq stocks. "The best support for the
bullish case continues to come from the ‘dollar-weighted’
QQQQ ratio," Shartsis observes, "which is now near $1.50
[meaning that option-buyers have purchased $1.50 worth of
puts for every $1.00 worth of calls], about equating to
where it was at market lows in March and May of 2004. This
is not all that far from the $1.76 it reached last August
(high pessimism). By comparison, at the market top last
December, this measure got down to about 53 cents traded in
puts for every $1.00 in calls (high optimism)."

Also worth noting, according to Shartsis, is that fact that
the American Association of Individual Investors sentiment
survey continues to register extremely high numbers of
bears. "The latest week had only 27.7% bulls compared to
43.9% bears," he reports. The four-week average of bulls to
bears has fallen to lows that have been seen only three
times in the past five years: July 19, 2002, Oct. 4, 2002
and Feb. 7, 2003 through March 7, 2003 (from
Sentimenttrader.com). Those were the three most important
buying opportunities since the market peak in 2000.

"It is possible," Shartsis concludes, "that the current
rally phase, after a possible setback early this week, will
then spike up into April option expiration at the end of
the week."

Meanwhile, an entirely different gauge of investor
sentiment seems to corroborate the signals that Shartsis
has observed. Mutual fund investors within the Rydex fund
family have been moving their money from "bull" funds to
"bear" funds – a trend that often presages a stock market

[Rydex is the fund family famous for pioneering index funds
that SHORT the stock market. The Rydex Ursa fund, for
example, "seeks to provide investment results that
inversely correlate to the performance of the S&P 500
Index," the fund’s prospectus explains. Rydex has become a
fairly sizeable operation that runs 45 mutual funds,
including 18 sector funds and 8 "inverse" (or short) funds
that move opposite the market.]

By monitoring the cash flows into or out of the various
Rydex funds, one can gauge the approximate mind-set of
investors. When they are bullish, for example, they buy
"bull" funds and when they are bearish, they buy "bear"
funds like Ursa. These trends function well as contrary
indicators because, as the nearby chart illustrates, Rydex
investors often become too bullish at market peaks and too
bearish at market lows. When the cashflow line (bottom half
of chart) is trending down, the cash flow into bear funds
is increasing, and vice-versa.

Note that cash was flowing heavily into bear funds last
August, just as the market was about to launch a major
rally. Presently, Rydex investors are once again upping
their allocation to bear funds and money market funds,
which suggests that a rally may be approaching.

"On the chart above," observes Carl Swenlin, the chart’s
creator and founder of Decisionpoint.com, "The two Ratio
lows in January and March represent short-term oversold
points, but the real benchmark is set by the Ratio lows in
August 2003 and August 2004. When this level is reached
again, it will probably mark an intermediate-term price

Lastly, the implied volatilities on call options for the
XLE (an ETF of oil stocks) compared to the S&P 500 tell a
very interesting tale. (Please stay with me on this one…)

Stated VERY simply, call option volatilities tend to rise
as prices of the underlying securities rise. But when
volatilities rise far above normal ranges, a peak in prices
is usually close at hand. Conversely, when call
volatilities fall to low levels, a rally is often close at
hand. We will not concern ourselves with the complicated
whys and wherefores of this phenomenon, we will merely
highlight it.

As the nearby chart illustrates very clearly, call option
volatilities on the XLE and the S&P 500 tracked each other
quite closely over the past several years. But their paths
began to diverge about two years ago. The divergence
unfolded slowly at first, but then accelerated last fall as
the price of crude oil soared to $55 a barrel. Currently,
the volatility on XLE call options is DOUBLE that of S&P
500 call options. Clearly, these two data series could
continue to diverge, but we wouldn’t bet on it. Rather, we
would expect these volatilities to re-converge, as the
crude oil price continues to correct or the S&P rallies or
both…At least that would be our best guess.

In short, we continue to await a springtime rally almost as
giddily as we await warm weather, while bracing for a
springtime sell-off in commodities. Therefore, try to catch
a short-term stock rally if you like, but don’t forget to
re-commit at lower prices, hopefully, to the long-term
bull market in commodities.

Did You Notice…?
By Dan Denning

A quick note on the housing/mortgage lending bubble.

It’s starting to get more press, the way the Nasdaq began
to make investors nervous in 1999. Of course some investors
would shout you down and call you an idiot for suggesting
that things might, perhaps, be a little out of hand.

Last week I quoted Alan Greenspan on the nature of the
systemic risk posed by Fannie Mae (FNM) and Freddie Mac
(FRE). Those stocks are up off the mat and moving ahead
cautiously, despite the road ahead. But IYR and ICF, two
ETFs that track the real estate market (both of which are
optionable) are not having so good a go of it.

Foreclosure.com reported last week that 28,190 foreclosed
homes were put up for sale in March, a 50% increase over
February. And Robert Shiller, the voice crying out in the
wilderness during the Nasdaq bubble and author of
Irrational Exuberance gave an interview in NPR recently in
which he spoke about the way Americans are psychologically
affected by asset prices. Shiller says:

"There is an increasing perception that the price of assets
matters very much to our lives…There is indeed much to be
said for the ownership society in terms of its ability to
promote economic growth. But by its very nature it also
invites speculation, and, filtered through the vagaries of
human psychology, it creates a horde of risk we must
somehow try and manage."

Shiller shows that investors and homeowners are on the
horns of a dilemma. Asset prices DO matter because many of
us count on them for income and a way to save against the
day when our wage-earning power declines. But that is a
very different concern than wondering if condo prices in
West Palm will double and if you should buy now.

The best way to manage the risk of the mortgage bubble is
steer well clear of mortgage lenders, sub-prime lenders,
and home building stocks, and to also wait and see how
rising rates affect the whole financial sector, which has
become addicted to the easy credit the GSEs made possible.

You can also buy hard and tangible assets. In fact, the
Toledo Blade reports that the state of Ohio has been
investing in rare coins since 1998…Since the state waded
into the market, the Blade reports, it has split over $12.9
million in profits with its partner in the deal.

What is Ohio holding, you wonder?

How about a 1792 silver piece estimated at $2 million and a
bevy of 18th century nickels and dimes.

Real Estate Secret of America’s Blue Bloods

And the Markets…



This week

















10-year Treasury





30-year Treasury





Russell 2000


























JPY 107.89

JPY 108.30



Dollar (USD/EUR)





Dollar (USD/GBP)