The Contrarian, Wednesday, 02/18/2009 Staring into the Abyss by Robert Ogilvie Click here to email Robert

HAVING TROUBLE PRINTING?

Lately, there doesn’t seem to be anything but negative news and sentiment. On an overall basis, we have to take all of the information in and develop an overall opinion on where the average investor is emotionally. We have already seem some signs of capitulation but there won’t be any reversal until people stop talking about how bad life and the economy is and start living life. For the most part, most long term investors gave back the wealth that they accumulated from the extensive distribution of wealth that resulted from over inflated home prices and stock portfolios. It may be unpopular to say, but Main Street folks aren’t meant to have as much wealth and live as well as we all quickly became accustomed too. As a society, we will adapt to a lower quality of life that too many people enjoyed. To quote my 7th grade social studies teacher, “you can’t all be doctors and lawyers; someone here has to be the ditch digger.” There has to be a natural balance of wealth. What we are all experiencing lately is the redistribution of that wealth. Hopefully we can find the proper bias to align your portfolios in order to gain as much from the volatility as possible. Just because the wealth is being redistributed doesn’t mean that we can’t try to force it in our direction.

We use the CBOE Equity Volume Put/Call Ratio rather than the cumulative exchanges Put/Call volume to create the 10 and 20 day moving averages shown below. Traditionally, the equity option volume has indicated the tendencies of the majority that we, the smart money (at least I hope), are monitoring for peaks in bullishness or bearishness to trade in the contrary direction. Contrarians have to be become amateur psychologists and identify whether or not the market is reaching mass hysteria or elation. An uptrending Put/Call ratio is generally bearish because it follows a spike high in call buying or bullish speculation. A down trending Put/Call ratio is generally bullish because is follows a spike high in protective put buying or bearish speculation. The 10 day moving average dipped its recent low of 0.712 on Monday February 9th. There was an initial spike in the 10 day moving average which signaled a Negative bias. However, the 10 day average ticked down on Friday the 13th which should have signaled a Neutral signal. Since the 10 day moving average held above the recent low there wasn’t any urgency to alter the signal. As mentioned in last week’s commentary “we will look for a confirmation of the new signal once the 10 day crosses above the declining 20 day moving average.” As of Wednesday’s close the 10 day moving average closed at 0.76 from 0.742. In addition, the Negative bias was confirmed with today’s close of the 10 day moving average above the Put/Call ratio’s 20 day moving average. The 20 day moving average closed Wednesday with no change at 0.746. SIGNAL: NEGATIVE BIAS

The quick explanation of the CBOE Volatility Index ($VIX) is that it is the implied volatility measure of the S&P 500 (SPX) options. The $VIX is a continuous measurement of implied volatility which basically assumes that there is no expiration. There is a lot more to the calculation of the $VIX and why it spikes and trades within various ranges throughout history. The most important factor is that the $VIX provides us with indications of investor sentiment. The peaks in fear are represented when the $VIX spikes up, which generally identifies option traders’ tendencies to pay very high insurance premiums for downside protection after the decline has mostly occurred. It is assumed that volatility represents the cost of insurance premiums to hedge a portfolio. As the market declines, the costs to hedge the downside increases. Spikes in volatility represents massive fear of portfolio managers that have waited too late to hedge and feel they have to buy insurance to protect against further declines. This is similar to buying auto insurance after the accident; it is too late and the insurance will cost the roughly the same as the repairs. Contrarian methodology looks to buy when the masses are most fearful and sells when they are most complacent. Buying stocks while staring into the financial abyss is difficult for most investors. This is because investors tend to flee rather than find an alternative investment. Fear and greed are overwhelming emotions that can cloud an investor’s judgment at inflection points. To beat these emotions we must become methodical by relying on various sentiment indicators. This will help us stray from the traditionally wrong crowd.

As of Wednesday’s close, the $VIX closed down slightly 48.46. However, Tuesday’s close higher resulted from a gap down and continuation down in the SPX. Today’s close above both the 10 and 20 day moving averages caused the 10 day moving average to close higher for a second day in a row. As the chart shows, the 10 day moving average has been choppy. This has resulted in many bias adjustments. However, at Wednesday’s close the 10 day moving average (44.7) closed slightly above the 20 day moving average (44.56). The moving average crossover confirms the Negative bias. SIGNAL: NEGATIVE BIAS

The benefit of creating the charts from the data collected from the Investors Intelligence polls is that the data can be presented in many ways. The chart above has been revised to show Investors Intelligence plots of the percentage of Bullish (Purple) and Bearish (Blue) advisers as well as the spread between the two polls (black line). We haven’t seen the traditional overbought/short signal levels, traditionally at bullish percent levels above 50%, foe a while. It should be mentioned that Negative bias is represented by any reversal downward in the spread. The level of bullish advisors decreased 1.2% to 31.1% while bearish advisers increased another 2.4% to 41.1% from last week’s 38.7%. The spread declined to minus 10%. Since the spread has resumed its decline and maintained a sharp slope downward, the Investors Intelligence indicator remains on a Negative bias. SIGNAL: NEGATIVE BIAS

SUMMARY: Here we go again. All three indicators are Negatively biased. The difference between this overall negative bias and the last one is that all three of the indicators are recently negative rather than being stale signals. One might look for a run higher before adding negative Deltas. Another tactic is to add Negative deltas on the initial test of the $VIX touching the 20 day moving average. Just to remind you these indicators are intended for informational purposes only and trading according to the signals is at the reader’s own risk.