Sunday, July 25, 2010

SP-500, GLD and GDX - Sentiment Trumps Everything


Markets rise when the preponderance of participants are buyers, and fall when the preponderance of participants are sellers.  One of the key ways to anticipate the pendulum swings of participant behavior, and therefore price behavior, is to evaluate sentiment.  Sentiment, more than fundamentals or technical analysis, trumps everything.
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When too many players are on the same side of a trade they eventually find themselves in a crowded position where most everyone around them has the same motivation – to reverse their position when the tide changes.
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Little by little, as participants slip out the back door by changing the bias of their position, the pendulum of price swings more sharply against the remaining herd in the crowded trade.  Inevitably, something akin to panic sets into the herd as they begin to aggressively reverse their position for financial survival.  The primary ingredient that causes price to catapult, up or down, is sentiment oscillation and capitalization from one sentiment extreme to the other.
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An astute market technician, investor or trader will look for those flash points where conditions are ripe for a market reversal.  It sounds easy to do, but remember that when the analysis is very convincing, the preponderance of market participants will disagree.  It seems that to be effective at market timing one needs to listen not to what others are saying, but to what the sentiment data represents as truth.
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With these thoughts as a foreword, let’s see what the current sentiment situation is for the SP-500.
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The following chart is from Market-Harmonics and assimilates 4 years of bull/bear percentage data from Investor’s Intelligence.  To this chart I have measured and notated in blue the percent change in bearish advisors per the Investor’s Intelligence data, for each downswing of the SP-500.  My notation in green is the percentage change in bearish advisors for the related upswing of the SP-500.  The price of the SP-500 is notated in black at each swing peak and trough.
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One of the most striking observations I have made of this data is that it appears the maximum pendulum swing in the bearish direction is a 20% change.  This occurred in Q1, 2008.  More frequently this percentage change has topped out at 19%, followed by 16%, 11% and smaller percentage changes.
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The obvious conclusion I come to is that our current bearish % change situation, at a 19% reading, is about at the maximum.  History seems to show that investor’s emotions, like a physical rubber band, can only be stretched so far into pessimism (19-20%) - the bearish direction - before they snap back in the opposite bullish direction.
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The pendulum swing in the bullish direction is about to begin at this very time.  Click on the chart to ENLARGE
















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I would expect that the stock market could not possibly peak until the % of bears decrease by a minimum of 8%, and more statistically likely 10-15%.  With a current reading of 36%, I am suggesting that we should not even consider a peak in the stock market until the bear percentage reading drops from where it is now at 36% to 28%, and more likely to around 26-21%.
  
What this means for now is that 1100 is not the top in the SP-500.  Far from it.  The bears have not even begun to turn into bulls.  Price will go much higher from here and it will take weeks, if not a couple of months, minimum, to reach a shift where the % of bears are themselves finally out of whack on the teeter-totter.
 
Gold, while not covered by Investor’s Intelligence to my knowledge, would appear to be in a similar setup as the stock market.  For this I turn to data published this past week at Schaeffer’s Investment Research and look at the 2 year history of the GLD put/call option ratio.

When the put/call ratio spikes high, it means that traders/investors are convinced that the price of gold will fall.  I have circled on the chart such instances from the past two years in red.
  
What we can observe is that when the bearish trade gets excessively crowded, when a preponderance of participants are convinced that gold will fall, that is not the top in gold.  Rather, it is the bottom.  I have circled with green the price of gold for each occasion of a put/call ratio spike.

Again, think about what is going on here.  When the put/call ratio spikes upward you have an intense perception and emotionally dramatic conviction of traders that substantially puts too many folks on the same side of the trade.  When gold starts to move against them, even just a little out of their expectation range, each owner of a put option is no longer a seller of gold, but becomes a motivated buyer of gold!  This is precisely how huge brisk run ups in price are both setup and then executed.  Click on the chart to ENLARGE






























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If I were presently short gold and looked at this chart it would send shivers down my spine.  No kidding.  Nothing like finding out you are in a crowded trade that once it starts to go bad, you KNOW it will go very bad.
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Now, I am not saying that the bottom for gold is in just yet.  Gold could still delight the bears and frustrate the bulls with one last brief maneuver lower this week.  But after that, if it happens, I believe gold’s low will most definitely be in and then there will be a lot of folks who will wish they did not hold puts on gold.
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While gold has not yet told us if the last shoe has dropped, the GDX miner ETF, however, is suggesting a favorable outcome.  The following daily chart is the GDX and below its price movement is the True Strength Index Indicator (TSI) with volume.  You can make you own chart and use the TSI indicator by visiting FreeStockCharts.
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On the negative side for GDX, the True Strength Index indicator reading is still barely below ZERO in negative territory (-0.06).  On the positive side, GDX is sporting a positive divergence between price and the indicator, a recapture of the uptrend line begun last February, a breakout of a 4 week price downtrend line and a breakout of the TSI indicator on increasing positive volume.  All in all, I regard this setup as bullish for GDX and most likely for GLD, as well.  Click on the chart to ENLARGE
























If you are interested in reading more about the techniques of using the True Strength Index (TSI) indicator, want to be exposed to discussion and analysis of various mining stocks, as well as the US Dollar and stock markets, or just want to participate in a blog where your thoughts are heard and responded to, I invite you to join me at my website which is:  The TSI Trader.  Or jot me an email, tsiTrader@gmail.com

I wish you a profitable week!

John Townsend

6 comments:

  1. John - As usual an excellent review. While gold and GDX look promising, the chart on silver appears more so. Add to that the now favorable COT position created in the recent sell off and we may have a rocket on the launch pad. But silver should respond negatively to the apparent approaching deflation. What say you?

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  2. Rick - I think you just hit yourself and our team a home run. Congrats!

    I just took a peek at SLV and the silver miner ETF SIL, and geez, they look great! Daily SLV and SIL have just broken above a downward price trend line, broken above the downward sloping TSI trend line and the TSI is above ZERO on BOTH. What more could a guy possibly ask for, except more volume?

    I would also note that the commodity complex in general is not validating the monkey business we are still seeing in gold. Check out a chart of the $CRB, $WTIC, $COPPER and DBA. All have made higher lows and higher highs - as has the $SPX,$TRAN, $RUT and $COMPQ I might add.

    You know, somehow this tells me that the market smells inflation, not deflation, and its probably a real good time to take gold AND silver seriously. Well, and add to that the current annihilation of the US Dollar and it all begins to add up, doesn't it?

    Making a mental note to myself to keep an eye on both SLV and SIL for our readers.

    Thanks Rick for your contribution!

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  3. Ah yes the heard mentality, the crowded trade, interesting points John.I trade from a bunker :) and only use charts,on occasion I wonder off to other chart sites like yours to see whats on the radar screen of the chart watchers. I completely remove the media spin from my investment decisions its all noise imo and rely solely on what the charts paint. The charts of $CCI, $WTIC, $HUI and $SPX tell me the DEflation/INflation trade is an on going tug-of-war especially these past 3 months. When a DCross occurs often a bounce back towards the 200dma takes place before the trend gathers momentum again, the $CCI chart is putting up one H of a fight trying to reverse a DCross which is very rare. Next week will be interseting as many charts we precious metals investors watch are bouncing nicely off July lows and imo the key gold level at $1212-16 will be a trend changer as it either turns back the bulls again or falls and $1225 taken out suugest anothe test of $1260+

    Cheers!

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  4. Compelling charts and arguments, John, thank you for your continued excellent analysis. I do note that we don't know whether the put/call volume or the GLD price have actually hit their extremes, they are still trending, no obvious top or bottom is in place. GDX is chopping down and chops tend to be symmetrical. The rise of the last chop low was 5 days and we are now 4 days from the most recent bottom. That says to me that Monday or Tuesday should be the top if we are going to continue the chop down. Then, price needs to fall below 46.99 to continue the chop down pattern. If Friday's low of 48.87 holds and price moves higher, the chop down will be over and I will change my bearish bias. If we do continue lower, I think it will be a short move down, but I think GDX could see 44-45.

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  5. The great thing about the market is that everyone can be right if you just wait long enough. Of course, everyone is also wrong if you wait long enough. So, for GDX this coming week, we could see a break up that would take it to between 51-53 on weak momentum to a top and then down to a new low. For example check out GDX from 1/4 - 1/11/2010, 6/25 - 7/1/2009, 4/16 - 4/17/2008. Watch the MoneyFlowIndex if we see a rise early this next week to see if it moves up strongly, or lags. I think that will be key in determining whether it is a short term rally or the start of an up trend.

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  6. Garry -- thank you for your detailed thoughts. I gave each one some thoughtful consideration. FreeStockCharts was not able to take me back to April 2008, but I do know that June '09 was the end of the B wave and Jan '10 was the end of the last weekly cycle. Whether we have already or are instead about to conclude this current weekly cycle is unknown with certainty. It seems these weekly cycles end with a sky dive shakeout on heavy volume, and we just have not seen that yet.

    One of the things that continues to utterly astound me is how accurately the TSI performs. It told me when to get out in the 2009 episode you cited (7/2), and when to get in after the 2010 episode (2/5).

    I mention this because, being human, I don't always trust that it could be so accurate.

    Right now it has given me a positive divergence (higher lows TSI while lower lows price) and a TSI trend line breakout. My gut tells me there 'should' be another shoe to drop. The indicator tells me the show has begun (ie. just buy).

    So, I intend to proceed trading this week with the positive bias that it insists I listen to, and I guess we will all see if it is the indicator or I who has the last laugh.

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