Bearish Sentiment Has Been the Cocktail For a Rally

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"Abbott: Who's on first, What's on second, I Don't Know is on third base.

Costello: You know the fellows' names?

Abbott: Yes.

Costello: Well, then who's playing first?

Abbott: Yes.

Costello: I mean the fellow's name on first base.

Abbott: Who.

Costello: The fellow playin' first base.

Abbott: Who.

Costello: The guy on first base.

Abbott: Who is on first.

Costello: Well, what are you askin' me for?"

-- Abbott and Costello, Who's on First?

The rally from last Thursday's lows is taking hold, with the S&P 500 futures up another 18 handles at last check this morning. If we close higher today, that will represent the first three-session winning streak so far this year.

Global equity markets have since Thursday begun to exhibit signposts of stability and improving strength just at a time when many investors were turning more bearish. Indeed, this rally is in many ways among the most-hated one that I can remember (and that's generally a bullish sign).

Deep-oversold and profoundly bearish investor sentiment has already been a cocktail for stocks' two largest consecutive-day gains since last August.

Superimposed on the improving momentum are the hands of gamma hedgers, risk-parity traders and other quant strategies that -- like Pavlov's dogs -- hear the momentum and "move" the averages ever higher. I'm convinced that these disruptive market influences have rendered interpreting charts a more-difficult and less-valuable exercise (at least for now).

As I noted both four weeks ago and again late last week, numerous precedents and positive technical divergences have led to our current sharp rally, including the fact that:

Despite the S&P 500 and Dow Jones Industrial Average recently hitting fresh lows, only about 50% as many New York Stock Exchange-listed companies hit new 52-week lows this month as did so in January.

The percentage of stocks trading above their 50- and 200-day moving averages was higher at the recent low than it was at the market's January low.

The McClellan Oscillator and Summation Index recently held at higher oversold levels.

Other support features of a better market over the last few days have including a rally in Shanghai, improving European stock prices and a sharp reversal in higher Treasury yields and lower Treasury prices. (I made a short of the iShares 20+ Year Treasury Bond ETF (TLT) last week's "Short Trade of the Week.")

Wall Street's recent laggards -- financials, transports, cyclicals, energy, commodities and industrials -- have also been on the offensive and become the market's recent leaders. Even the oil sector has rallied hard despite just a weak bounce in oil prices.

Conversely, the market's recent leaders have gone on the defensive and become laggards. But as I've previously pointed out, leadership changes often accompany a weak overall market -- so we have to stay alert.

And as I've also written recently, investor sentiment has gotten back to a negative extreme. The number of bulls minus bears among investment-newsletter writers is exceeding the previous wide spread seen five years ago.

However, all isn't perfectly aligned for a rally. For example, while we've had two consecutive "80%-up days" (sessions where 80% of stocks rose), this has come on weak volume instead of strong action. A sustainable contrary rally could need support from heavier volume.

There are also some dissimilarities between our recent January low/February test and last year's August-to-September sequence (which led to a vigorous five-week rally in the fourth quarter).

You might remember that on the strength of the rally back in October, I began to expand my short exposure. I felt that stocks' August-to-September move higher wasn't a replay of the 2011 summer-to-fall correction that led to a new bull-market leg.

My principal objection then was the deteriorating prospects for global economic growth and corporate profits, coupled with a reduced confidence in central bankers (what I call the "Ah Ha Moment") at a time when the market prices were advancing mightily.

Although the first seven days of last October's rally had strong 3-to-1 or better breadth, the notion of a bullish replay didn't work back then. And in all likelihood, the market will also challenge our current market rebound (although perhaps from higher levels).

I wrote on Friday that the next week or so will be critical. I still hold that view.

The conventional wisdom is that the S&P 500's support level is at 1,810, while 1,950 is the resistance. But everyone sees the same charts, so that's "first-level thinking." As I've often noted, disruptive quants and their machines and algos have "dirtied the water" and likely rendered chart reading less valuable.

Like Abbott and Costello, many traders and investors are confused by who's on first these days. I think the safest play is to lean conservatively positioned and see if we get a high-volume/high-breadth thrust confirmation in the days ahead.

It's even more important to continue to evaluate the fundamental backdrop. For me, looking at a stock's intrinsic value vs. its current market price is my sine qua non.

I'm starting the day slightly net long, but the S&P 500 closed yesterday at 1,902 vs. my fair-market calculation of 1,860. So, risk vs. reward will deteriorate if the market's recent rally gathers speed.

The Bottom Line

This is what I wrote yesterday morning:

"The Jan. 20 "noon swoon" provided a recent good opportunity for traders. The S&P 500 quickly followed an intraday test of 1,812 that day by a move to about 1,935.

Another opportunity for traders has arisen since last Thursday. The S&P 500 has followed last Thursday's retest of 1,812 by a tradable move to almost 1,890.

Rather than get caught up in the 'dogma' of a view, I prefer to unemotionally assess the pendulum of volatility and the discounts or premiums to the fundamental intrinsic value of individual stocks, sectors or the overall market. I use that as a guidepost to my short-term trading.

Thus, I moved from a net-short position to a net-long one during both late January's swoon and last week's scary market drop, because discounts to intrinsic value widened during both events.

Catching 5%+ bear-market rallies (and even-larger moves in individual securities) might not be for everyone. But in an investment world defined by low or substandard returns, opportunistic fundamental traders shouldn't bury their heads in the sand and sit on the sidelines as these opportunities arise. Rather, flexible traders will take advantage of these moves."

-- Doug's Daily Diary, At a Good Turn, You Will Not Want to Buy (Part Deux) (Feb. 16, 2016)

The market's recent sharp advance is encouraging, providing another contrarian move (and very profitable trading backdrop from Thursday's lows). Those trading profits that have been realized can't be taken away from us.

But the rally isn't yet convincing enough for me to expect anything different than what we saw after the S&P 500 hit its Jan. 20 low of 1,812.

So, I'll get more cautious if the market rolls higher and risk vs. reward deteriorates, unless we see a higher-volume/higher-breadth thrust upward. In other words, unless the fundamentals improve -- which isn't my baseline expectation.

 

Doug Kass is president of Seabreeze Partners Management Inc. 

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