More Bullish Evidence

There is a scene in Rocky III where a reporter asks Clubber Lang (played by Mr. T) about his prediction about the upcoming bout against Rocky Balboa (played by Sly Stallone) whereas his response to the question was, “My prediction…Pain”.

With all the tough talk stemming from European leaders last week we found it apropos to link it to this boxing analogy. In one corner stands Mario Draghi, head of the European Central Bank and in the other are the bond vigilantes that have wreaked havoc on the European sovereign debt markets. Mr. Draghi’s statements last week offered a similar but sterner tone towards the European debt crisis in saying that the ECB will do everything in its mandate to support the common currency and ended the comment with, “and believe me, it will be enough”. Further comments by German Chancellor Angela Merkel and French President Francois Hollande that they are “deeply committed” and “determined to do everything to protect” the euro offered the proverbial one-two combination that sent Spanish and Italian bond yields plummeting and European and U.S. stocks soaring.

The question remains if there will be sufficient follow-through with tough action. The obstacle remains that the Bundesbank continues to oppose additional ECB bond purchases and the granting of banking oversight by the European Stability Mechanism (ESM).

Regardless of the coming match, European leaders were successful in bringing the Italian ten-year back below 6% as of the time of this writing, down from almost 6.6% last week while the Spanish yields are 6.5%, down from 7.5% last week.

Further declines in these bond yields mean different things for different investors. It will certainly hurt those investors betting against Spanish and Italian bonds. It will hurt those that have positioned assets in safe havens, that is German Bunds and to a lesser extent U.S. Treasuries. It will be a negative for investors in the U.S. dollar vs. the euro.

On the other side of the coin, investors in Spanish and Italian bonds may see capital appreciation in their holdings, investors in the euro and short sellers against the safe havens will benefit. Most importantly, as it related to investors in JSK Partners, equities will benefit from this sector rotation of assets.

We have been building our long positions within the U.S. equity markets and continue to believe the current events from Europe (while even short lived) will benefit our customers’ returns.

Short Squeeze?

There are investors that “bet” against the market by selling equities short. This means an investor will go to the market and borrow shares of stock and sell them in the hopes of being able to buy them back at a later date for a cheaper price and thus capturing a profitable spread when that investor then returns the borrowed shares.

One can track the amount of short sales by tracking the short interest ratio. The short-interest ratio is the number of shares sold short (short interest) divided by average daily volume and it provides insight, based on the market’s average trading volume, on how many days it will take short sellers to cover their positions.

Based on information from Bloomberg, the current short interest ratio for the entire market is 4.6 days. In a vacuum this means little, but when compared historically, this figure is exceptionally high. So high that it lies outside two standard deviations from the mean, or put another way, this ratio reaches this level in less than 1% of the historical observations over the past five years.

Basically, there are MANY investors betting against the market right now. European fears, a weak U.S. economy, soft corporate earnings and an exceptionally negative Presidential election cycle surely influenced these pessimists. Add on top a major market call by Goldman Sachs several weeks ago telling investors to short the S&P 500 and one can see why investors have soured on stocks.

That said, there is a catch. Shorting stocks can potentially offer unlimited downside risk so investors are quicker to exit the trade if that trade moves against them. This is called a “short squeeze”. Given the S&P 500 and most other major indices have rallied on stronger than average volume and appear to be breaking above key resistance levels, one may see further market upside through excessive short covering.

A potential short squeeze can push the markets to new highs for the year. This will be a net benefit for our investors and we continue to adhere to a bullish investment thesis over the near-term.

Investor Sentiment

One item we tend to track is the American Association of Individual Investors (AAII) Sentiment Survey. Taken from their web-site, “The AAII Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months; individuals are polled from the ranks of the AAII membership on a weekly basis. Only one vote per member is accepted in each weekly voting period.”

This survey has been used in the past as a contrarian indicator.

Market pessimism, as measured using the AAII Survey is hitting extremely elevated levels. Right before the recent market rally, only 22.2% of respondents to the survey claimed to be bullish compared to 41.8% that are bearish.

Using a ratio of bulls-to-bears, that figure is now just over 0.53 (22.2/41.8). This model is typically used as a contrarian indicator, so bull-to-bear readings below 0.543 indicates there is extreme pessimism in the market and there may be a coming “bounce”.

As a contrarian investor, these are indications to keep our bullish stance in place and further reinforce our view that the markets will provide further upside from these levels.

Trend Analysis

Two weeks ago we highlighted our Parabolic time-price analysis that indicated we had entered a new uptrend in the market. Last week we received confirmation of that new uptrend through the Commodity Channel Index.

When using this model against the weekly S&P 500, it has been instrumental in providing us clues as to market direction and protects us from sticking around during a market correction.

Figure 7 shows how this model behaved over the past five years. It has been instrumental in picking appropriate entry points and more importantly, has kept us out of declining market situations.

We are encouraged by the fact that two of the trend tools that we use in determining investment policy are in agreement with one another and offers further conviction that we are on the “right side of the trade”.

We are getting bullish signals and we will watch our proprietary behavioral and fundamental models as well as those supporting models to determine our next moves.

Joseph S. Kalinowski, CFA