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August 18, 2007

The Bears Get Sentimental on the Market
by Clif Droke

For a while there this past week it looked as if the bears would be proven correct on their super pessimistic market outlook. It also appeared as if the Big Boys on Wall Street would actually be proven wrong while the small traders and outsiders would be justified in their short selling and heavy purchasing of put options. It almost seemed as if the market was about to ignore every known rule of the Contrarian Principle and was going to smash through every significant support level on its way to a major crash.

Appearances can be deceiving, however, especially in this, the most volatile of businesses. What started as a rout of the major indices this week ended with a strong reversal and recovery as signs of institutional buying finally showed up on the tape after a dismal showing earlier in the week. Already there are many similarities to the bottoming process taking place now compared to the one of just over a year ago when the Dow made a major low in June-July and followed up with a rally to new all-time highs. If the indicators are of any value right now, they're telling us of a similar high-profit potential move coming up once we get through the current bottoming process.

There are many similarities in the market sentiment profiles of both the summer 2006 decline and the summer 2007 decline. At the low in summer 2006, investor psychology hit one of its lowest readings in years as measured by the Total Put-Call Ratio. If you will recall, fear was heavy in the air and the newspaper headlines were rife with gloom and doom. This latest market correction low was no different with near record put buying and bearish sentiment. Newspaper headlines continue to fret about one crisis after another. Assuming history continues to repeat, then the current high levels of fear and pessimism should eventually translate into gains for the stock market as the ever-growing fear continues to bolster the market's "Wall of Worry."

While doing my daily news headline clippings this past week I came across the word "gloom" or "gloomy" on the front page of several newspapers. These words doesn't show up very often in the headlines but experience shows that whenever they do it marks an important bottom in investor sentiment and that the market's decline has been overdone. Here are some of the latest headlines: "Bear gloom drags markets down," "Wal-Mart and Home Depot cast shadows into deepening gloom," "Home Depot in gloomy outlook," "A trip to the grocery store is enough to make people gloomy about the economy." Never underestimate the contrarian power of the word gloom!

I received a thought-provoking e-mail from an old Internet friend today that I thought I'd share with you. This colleague, a successful institutional trader, has a long-term history of being right in its market assessments since my association with him began several years ago. He writes:

"I can't help thinking that this whole overdone correction is exactly what the large investment banks have been banking on. Whilst corrections are a part of normal market fundamentals I think it is obvious that the degree of negativity that is being portrayed to investors by the media is being somewhat overdone.

"Liquidity drives markets and the 14000 level on the Dow was always going to be tough a cookie to crack.

"Now the big investments banks have, with some opportunistic help from the sub-prime market created a crisis that has forced the Central banks to intervene and will ultimately lead to an increase in liquidity across the board and thus provide just what is needed for the markets assault on new levels above 14K.

"I can't think of a more bullish scenario than what is currently underway. Think Asian crisis and the LTCM debacle in '97 [sic] and what the final result of that liquidity injection was."

Agreed on all points!

A long-time friend and colleague made an interesting observation on the phone today that I couldn't help echoing: "The stock market always comes back to its true level. If it ever gets below that level [like it did in the recent correction] it always returns to its proper value. Sometimes it takes only a few days or weeks, and if the market is overvalued enough it might take months or even years in a bear market before the damage is thoroughly repaired and the market returns. But the market is just like water behind a dam. If the dam breaks and the water spills, the water will eventually rise back to its proper level behind the dam once the dam is repaired."

In view of the stocks market's current 35% undervaluation in relation to the 10-year bond yield, does any rational investor doubt the market will eventually seek its "true level" once the current fear subsides? That true level is undoubtedly at a much higher price than the one we're seeing today.

I also had a telephone discussion with another industry colleague on Friday and we both agreed that had the market, against all odds, broken down even further and plunged lower than it did on Thursday of this week, it would have represented the buying opportunity of a lifetime. The recent decline was and still is a great buying opportunity and there is strong evidence that insiders have been buying stocks as heavily now as they were at the last bear market bottom in early 2003 (according to the Gambill Oscillator of insider buying activity). But the more I think about it the more it becomes clear that this attitude toward market declines is what separates the bulls from the bears: the bears view declines such as the one on Thursday, Aug. 16, as a selling opportunity while bulls view it as a buying opportunity. Which posture is correct depends mainly on market fundamentals and the psychological profile of the market.

What's the essential difference between a bear market and a bull market? In a bear market, declines in the stock indices only pave the way for lower levels to be made. In a bull market, declines are basically buying opportunities. While many dispute that we're still in a bull market, the indicators argue otherwise. Bear markets don't begin with investor sentiment this low (i.e. with near record put buying and short selling on the part of small investors). Bear markets don't begin with stocks this ridiculously undervalued (35% according to IBES) compared with bond yields. They don't start with heavy insider buying (with SEC filings showing the heaviest insider buying rate since the previous bear market ended in 2003). And they typically don't begin at this point in the decadal rhythm (the last two years of a decade are normally bullish). Anyone who is betting that we've entered a new long-term bear market is betting against the clear testimony of history and against the most powerful and consistently reliable market indicators. I'm not one to go against the laws of probability, so for all the bears which have chosen to do so all I can say is "good luck!" to our fuzzy friends.

Up until now the stock market has been mostly an insider's affair with the Small Investor not being invited to participate. He has been consistently scared away by a ceaseless fear campaign in the media that has been underway since 2004. Every time the Small Investor gets even remotely bullish on the stock market he is again scared away by a sudden correction and the fear of an even greater decline that always comes with it.

When will the Small Investor be invited back to participate in this bull market? When the Big Money has finished the game of scooping up shares at undervalued prices then it will be time for the inevitable pay-off. The pay-off behind every major insider accumulation campaign is an unloading and distribution campaign where the Big Money investors realize a vast profit on their cheaply purchases stocks. The media will gradually lift the veil of fear and today's crisis-laden headlines will be replaced by cheerful headlines glowing with optimism. This in turn will cause the Small Investor to become even more bullish as he greedily buys all the stocks the Big Money pours onto the market. Thus will end the mark-up phase of the current bull market. Bull markets don't end until the Big Money realizes a vast profit on its cheaply acquired shares. That hasn't happened yet.

Turning our attention to the precious metals markets, the Amex Gold Bugs Index (HUI) was up 2% on Friday to close out the week at 306.19. The XAU gold/silver index was up almost 3% to close the week at 129.36. The spot price of silver closed at $11.73.

The XAU index closed well off its low for the week of 120 on Friday but is coming off a much deeper correction low than the broad market S&P 500. This lagging behavior isn't really surprising since gold stocks nearly always bear the brunt of a broad market sell-off. Investors are always quick to dump the gold stocks when they're desperate for cash and this is why PM stocks usually take the hardest hits at a correction low.

But what started out as a rough-and-tumble week for equities in general and for the precious metals and PM shares in particular ended up being promising in terms of a market bottom now in formation. The selling of the past week was clearly overdone and now there is evidence that the "smart money" is returning to buy heavily the beaten down PM bargains.

The best news the market is offering us right now comes from the 20-day price oscillators. The XAU 20-day price oscillator has hit its lowest reading in several years and I can't remember when I've seen it lower than it is now (see chart below). This shows the market is stretched like the proverbial rubber band at the breaking point and I can't see it stretching much further without snapping back and giving us an oversold rally and probably one lasting several days.

One thing that's very common following intraday reversals such as the one we witnessed on Thursday-Friday is for a rally to follow soon on the heels of the initial reversal. However, it's almost inevitable that there will be a re-test of the intraday lows at some point before the month is out so we'll need to be prepared for this. The re-test, even if only a partial one, will let us know for sure how much strength is left in the PM stock market, especially when compared to the call/put open interest ratios we follow.

Clif Droke
ClifDroke.com

Clif Droke is the editor of Gold Strategies Review., providing forecasts and analysis of the leading North American small cap, mid-tier and senior mining stocks from a short- and intermediate-term technical standpoint since 1998. He is also the author of numerous books, including "Channel Buster: How to Trade the Most Profitable Chart Pattern" For more information visit www.clifdroke.com

Copyright © 2003-2009 Clif Droke

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