The main purpose of the stock market is to make fools of as many men as possible. - Bernard Baruch
The market is set to make a move...a very big move.
And it could be in a direction that would surprise and prove very costly to a lot of investors.
The markets have been struggling for the past week. Yesterday's 200 point drop in the Dow was quick and widely anticipated. It's the strongest test the bulls have had in months. So far, they're not faring to well.
But as I watched the markets fall yesterday (normally at the Prosperity Dispatch, we try and avoid the day-to-day stuff) I couldn't help but wonder if it is a sign of reality setting in? Or is it just a healthy correction to suck in even more bulls into this rally?
As we've seen time and time again, no one knows the answer. But if we look at what's going on in the markets, we can get a good idea of what's likely to happen next. And a few indicators right now are showing the market's next big move may make a large and growing group of investors look like fools.
Are You Scared Yet?
The last few weeks have been tough on quite a few investors. Most investors are on edge. Take Dania Leon for example. She's a 41-year old Pasadena resident who has held out throughout the ups and downs of the past year. She's the typical investor. She recently told the Los Angeles Times:
I'm scared, I'm scared, I'm scared. Why are we up, especially with unemployment as high as it is? I don't feel great because I worry that we could have a 500- or 600-point drop in a day and I won't be quick enough to pull out of it in time.
That's how most investors are feeling right now. But if we look at the markets, the case for something more extreme than most anyone is expecting could be just around the corner.
Expect the Unexpected
The bear's confidence is strong and the recent downturn is only strengthening that confidence. The bears' conviction has been strong for months though and the markets have just kept going up.
That's why, as contrarians, we should be looking at the what ifs that no one is expecting. Remember, the market has a tendency to do the exact opposite of what most market players are expecting. That's why, in the short-term, we could see the run-up...hold onto your hats...continue.
The amount of bearishness out there is still extreme.
A little over a week ago James Grant, a well-known and highly-respected perma-bear, officially turned bullish. In his Wall Street Journal article, From Bear to Bull, Grant made a case for why the market could sustain current levels and the economy could recover much faster than most folks expect.
But here's the thing. Grant was universally maligned. He has been the steady hand of the bears for years. And he has been a welcome ally during this rally. His proposal about a quick economic recovery was attacked from all sides. It was almost like the bears took it personally.
The near-universal vilification of Grant's betrayal is just anecdotal evidence of how much bearishness still remains. There's firmer evidence in the bears' conviction. And it's something that doesn't happen often.
Holding on Tight
Back when the evil short sellers (those who bet against stocks) were being attacked from all sides (it's almost too easy to attack someone who's making money when most others are losing it), we looked at the reasonable and value-added role they play in the market. Still though, the short sellers on Wall Street aren't a popular bunch when it comes to public opinion. But they can help show us where the market may be headed next.
Every couple of weeks the major exchanges publish short interest data - the total number of shares sold short. This way you can see how big the bets are against the stock market as a whole.
Normally, short interest increases as markets go down. In a downtrend, the hot money traders get on board to ride the trend for all its worth. In an uptrend, short interest will decline. Shorts have to cover, or buy back, their bets against stocks.
That's all the rules for a relatively normal market. We're still a far cry away from normal and that's why I'm extremely interested in the recent short interest data.
Between February 27th and September 15th, the NYSE Composite Index climbed 53%. The strong rise was widely attributed to not-as-bad-as-expected earnings, recovery hopes, and short covering.
The rationale made sense on paper, but it wasn't completely true. The short sellers have actually held on tight. Consider this. The total short interest on NYSE stocks was 14.18 billion shares at the end of February. The total short interest sat at 13.52 billion shares in mid-September. That's a decline in short interest of 4.7% while the market has risen more than 50%.
Clearly, the bears are holding on tight and short-interest is still as high as it was when the markets seemed like they would never turn around.
The Chicago Handicappers
Finally, there are the scalpers, so named for their neutral trading strategies, on the floor of the Chicago Board Options Exchange (CBOE) who have a way of handicapping the markets.
The total bets placed on both put and call options (bets that stocks will rise or fall, respectively) are tracked in relative fashion via the CBOE Put/Call Ratio.
Yesterday the put/call Ratio rose to 0.73. This means there were 100 call options purchased (bullish) for every 73 put options purchased (bearish). This is only slightly bearish though. The 5-year average put/call ratio is 0.65. The lowest it has fallen is 0.32 and the highest was 1.7.
Clearly, the big money traders may be bearish, but there's still not a lot of conviction when it comes to buying put options to capitalize on an absolute market rout.
The Easy Move and the Right Move
Although no one can predict what the market's next move could be, we can see how the market's next move very well could be to the upside.
There are many catalysts.
Earnings season is just around the corner. Although the first few companies to report haven't fared so well (ref: Research in Motion), but that's hardly a confirmed trend.
Also, the jobs situation may not continue to deteriorate. After today's terrible report (263,000 net job losses last month) , it's tough to imagine, I know. But we're nearing a period of relative calm in the U.S. economy. A period that may allow hamstrung managers to start hiring again.
The healthcare debate is winding down. Whatever happens will happen. The key thing for employment here is the debate will be over and all the uncertainty that goes along with it too.
Business owners will know how much extra it will cost to hire someone new or bring a part-time worker on full-time. As a small business owner, I can tell you this is a huge drag and a concern. So whether it's good news or bad news, the simple fact we have certainty will go a long way.
Also, the big tax hikes in capital gains, income, and consumption with a European-style Value Added Tax (Idea!: to get consumers spending again, we'll increase the price of everything), should be some time away.
Finally, we can't forget the Fed's continuing to pump freshly printed dollars into the system. The long-term costs will be high, but the short-term can lead to crazy euphoria's. Remember the Fed took unprecedented action in 1997 to combat the Asian Currency Crisis. Then in 1998 it took unprecedented action to combat Russia's debt default. What followed in 1999 was one of the greatest speculative bubbles in history. Money, regardless of how new, will chase something.
In the end, any market correction will only make the bears even more confident. The bigger bearish bets could easily add another leg to this rally. Stay on watch for the market to go either way. To stay married to either bullish or bearish stances would be very risky.
The best advice I have right now is the same as always. Continue to look for undervalued opportunities which offer the lowest risks and greatest rewards. Although all of them will not work out, sticking to investments which offer such a value proposition will go a long way in preventing the stock market from making a fool out of us.
Chief Investment Strategist, Q1 Publishing