"Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful." — Warren Buffett
Summary
- Short interest is at levels associated with significant bottoms
- Commercial futures positions are at levels associated with bottoms
- Put/call ratio and spike in VIX also at levels associated with market bottoms
For the past few articles I've been making the case that the market is in the process of bottoming. For concrete evidence that THE bottom (and not just A bottom) is in we need to see the major indices move back above their 50-day moving averages. I would also like to see a decent rally in the market’s weakest areas recently: junk bonds and small cap stocks. If we see these things happen, then we can breathe a sigh of relief that the recent market weakness wasn’t “THE BIG ONE” that many are anticipating.
However, if the above does not happen, we may have some more digestion to go through before a solid bottom materializes that the markets can advance from. If we do see some weakness ahead I would advise against turning apocalyptic for reasons I'll show below.
Through this cycle, I've witnessed investors jump in and out of the market at every sign of doom, usually to buy back at higher prices or give up completely. Unfortunately, as Warren Buffett implies, investors tend to be their own worst enemies when they can’t keep their emotions in check. They are bullish at tops and bearish at bottoms, compelled by herding instincts prior to major turning points.
Of course, this isn't just true of the investing public, but also with financial news media, book authors, and even recognized market experts.
The cyclical nature of the market is due in part to the predictable reactionary swings between fear and greed among crowds. We see euphoria and "irrational exuberance" at secular bull market tops and outright despair and fear at secular bear market bottoms. I highlighted this previously in a controversial article (see here) with the following two charts featuring what have now become well-known books and magazine covers as a study in contrarian investing.
Source: Bloomberg
Source: Bloomberg
Not only do we see that investors get it wrong at major secular turning points, we also see their emotions get them into trouble at smaller ones within cyclical bull and bear markets. This can be shown when looking at short interest levels on the New York Stock Exchange (NYSE). Short interest levels rise as investors become overly bearish and fall when investors become overly bullish. Currently, short interest is at levels that have marked significant bottoms (see blue arrows) since the bull market began and argues for investors to not get too bearish right here. The time to become bearish is when short interest is low (see red arrows).
Source: Bloomberg
Another indicator we can use to gauge market sentiment at tops and bottoms is the net long futures position of large speculators (hedge funds). Hedge funds, which tend to dominate the large speculators segment in the Commitment of Traders (COT) report, have tended to be more long at market peaks and more short at market bottoms. Their tendency to get it wrong at market turning points has led to their dismal performance since the bull market began (“Hedge Funds Trail Stocks for Fifth Year With 7.4% Return”).
Commercial hedgers on the other hand tend to take the opposite side of hedge fund positions and are bullish at bottoms (more long) and bearish at tops (more short). Currently, we can see the net long position for commercial hedgers is near the upper end of the range over the last five years for both the Dow Jones Industrial Average and the NASDAQ 100. Given the track record of commercials versus hedge funds it appears now is not the time to be bearish.
Source: Bloomberg
Yet another tool at measuring sentiment comes from the options market and the CBOE Volatility Index (VIX). When we see spikes in the put-to-call ratio and the VIX we are usually close to a bottom. Currently the put-to-call ratio is at its highest level in a year and the 24-day rate of change in the VIX is the fourth biggest spike in two years, suggesting that we are at or close to a bottom.
Source: Bloomberg
Outside of sentiment, another reason not to turn bearish yet is that the bullish trendline for the Russell 2000 that has been in place since the bull market began in 2009 is still holding. In the past, whenever the Russell 2000 has touched this trendline we’ve seen important lows that marked the next leg up in small cap stocks. If the Russell 2000 can hold its current level then it is quite likely we’ve seen yet another significant low in the markets. Should this line break, however, we need to take note that a more serious correction may be in play and put our risk management hats on.
Source: Bloomberg
Summary
“Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ... Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” — Warren Buffett
Tying in Warren Buffett’s advice with the data above suggests there is a healthy level of fear and anxiety in the markets currently and it may not be time to run for the hills. To determine whether the market has truly put in a bottom we need to see a surge in investor demand and the markets reclaiming some lost ground by rising above their 50-day moving averages. Should the markets fail to muster a charge out of this oversold condition we are likely to witness one more leg down, which should be characterized by less downside momentum and less downside participation as selling pressure gets exhausted.
