Tan, Don't Burn

Buy sunscreen, not Sun Microsystems…Such is the
approximate message delivered by several stock market
indicators, according to options pro, Jay Shartsis.

A dizzying array of troubling signs, omens and auguries are
warning that the stock market is due for a drop of some
significance. Net-net, August of 2005 might be a much
better month to buy coconut cocktails than common stocks.
"This summer," Shartsis says, "you’re less likely to get
burned on a beach than on Wall Street."

Since late April, all the major stock market indices have
staged impressive rallies, lifting the S&P 500 and the
Nasdaq Composite Index to four-year highs. Not
surprisingly, therefore, most investors have rekindled
their passion for common stocks.  Unfortunately, whenever
investors begin to love stocks too much, stocks begin to
abuse the affections of their admirers, by falling.

"Several gauges of investor sentiment are registering more
extreme readings than they did at the market top of March
7," Shartsis notes. "The 10-day CBOE put/call ratio, the
10-day Daily Sentiment Index (from MBH Commodity Advisors)
and the VIX Index of option volatilities are all showing
higher levels of investor bullishness – and lower levels of
fear – than they did at the market peak of March 7th.

"Before the March top, for example, the VIX dropped to
almost 12. That reading seemed pretty darn low at the time.
But guess what, last week the VIX hit almost 10, a new all-
time low!"

[Ed. Note: The VIX 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."]

"Yeah," we replied, "the VIX has become a somewhat less
reliable indicator over the last few years, hasn’t it?"
"Very true," said Shartsis, "but I still wouldn’t ignore
the message it is sending. Investor complacency is
high…and that worries me."

"What else is worrying you?" we asked.

"Well, not that it makes any difference at all," he
replied, "but Vickers reports that insiders are selling
more than five shares for every one they buy, and this
reading is up from a recent 3.1 sells for every 1 buy."
"Presumably, the insiders know something more than
nothing," we noted.

"Presumably," the options pro concurred. "Or maybe they’re
just as stupid as the rest of the ‘smart money’ has been
lately. I do find it interesting, however, that commercial
futures traders have become heavy sellers of stock futures.
This ‘smart money’ crowd of traders has been increasing its
net short positions in Dow, S&P and NDX futures. In fact,
the Commercials are holding their largest net-short
position in S&P futures since late January – shortly before
the market tumbled."

"So who’s buying?" we wondered.

"Who else?" Shartsis replied, "the ‘dumb money.’ One of the
most notorious ‘dumb money’ groups has become mega-bullish.
The small-time option traders – those who buy or sell less
than 10 contracts at a time – have been aggressively buying
into the market. On only two prior occasions in the last
five years – July 21, 2000 and Jan. 16, 2004 – did small-
time options traders buy more call options than they did
last week. On both of those two prior occasions, they soon
regretted their buying binges…and they probably will
again this time."

"Interesting. What else troubles you?"

"Well, I would interpret the declining volume in QQQQs as a
bad omen"

"Why’s that?" we asked.

"When traders are fearful," Shartsis explained, "they tend
to sell-short the Nasdaq 100 Trust Series ETF (QQQQ), which
tends to boost trading volume in the stock. So spikes in
QQQQ volume often signal a market bottom. Conversely, when
traders are highly confident, QQQQ volume diminishes. And
that’s what’s happening right now; QQQQs are continuing to
rally, even as the trading volume is sliding. I interpret
this divergence as a sign of complacency, and therefore, as
a warning of danger ahead."

"Okay, we will consider ourselves forewarned," we replied.
"Apart from the various sentiment indicators you mentioned,
are you seeing any other evidence of ‘toppy’ price action?"

"Sure, just take a look at the percentage of stocks above
their 10-week moving averages. In only about two months,
the percentage of NYSE issues trading above their 10-week
moving averages has gone from 16% to a recent reading of
80% – that’s a very overbought reading.

"Of course, it can stay overbought for a while. Last
November, this indicator got up to 84% and stocks continued
rallying anyway, until finally breaking down hard in
January. I would also note that when this gauge climbed
from a low near 12% in May 2004 to its high of 84% in
November, the process took six months. But this year, the
identical price spike occurred in only two months! That’s
some velocity, and is not a pace that is sustainable. So if
the percentage of NYSE stocks above their 10-week moving
average were to drop to 70%, I would take that as a clear
sell signal.

"For now, however, I’m just paralyzed," Shartsis concluded.
"This market is way too dangerous for my comfort level, but
its positive momentum dampens my enthusiasm for selling
stocks short. So I’m sitting on my hands. If I were long a
lot of stock, I’d be selling into the current strength. But
I wouldn’t sell the market short until we see some sign
that the market’s positive momentum is breaking down. We
haven’t seen that yet."

"Okay," we replied, "we’ll keep our eyes peeled. Anything
else bugging you, Jay?"

"Of course…But that’s what therapy is for," he quipped.
"I think I’ve said enough for now."

"Thanks Jay. Maybe we’ll see you out on the beach sometime
soon."

Did You Notice…?
By Carl Swenlin

The stock market doesn’t move in a straight line, rather it
zigzags higher (or lower) in response to alternate waves of
buying and selling pressure. When we speak of the market as
being "overbought" we mean that buying pressure has
persisted long enough that it is likely to be exhausted.

A good way to determine overbought (and oversold)
conditions is by tracking the percentage of stocks above
their 20-, 50-, and 200-day moving averages, indicators
which measure market conditions in the short-, medium-, and
long-term respectively. The chart shows this set of
indicators for the stocks in the S&P 500 Index, and you
will note that they are all approaching the 90% level, a
level that represents the most extreme overbought
conditions.

Another notable feature on the chart is how the price index
has been making higher highs compared to the series of
lower tops on the index showing percentage of stocks above
their 200-EMA (the exponentially-weighted version of the
200-day moving average). This is a negative divergence.
Also, both the price index and the indicator are
approaching overhead resistance.

During a bull market, overbought conditions are not grounds
for going short, but they will generally result in minor
corrections or consolidations, so it is a good time to take
a closer look at stop loss points. Since the bull market is
nearly three years old, I think a higher degree of caution
is warranted because the bull market is closer to its end
than its beginning.

And the Markets…