SCHAEFFER'S RESEARCH REVIEW
Prepared by
Investment Research Institute, Inc.
The Critical 30 Level
On The CBOE Market Volatility Index (VIX)
Two months ago in these pages we illustrated how the VIX can be applied as a very effective market timing tool by surrounding it with Bollinger bands, then watching for breaks above or below the bands. When the VIX closes above its top band, a market bottom is very likely being placed. Also, a market top is likely to occur soon after the VIX closes below its bottom Bollinger band. This method of analyzing the VIX on a “relative” basis is certainly the best way to use this indicator, but there is also something to be learned from watching the VIX's behavior near round-number levels.
Throughout most of 1996, the VIX remained in a range between 15.00 and 20.00. Closes above 20.00 were akin to breaks above the top Bollinger band because this was an excessively high mark illustrating climactic pessimism. Indeed, this proved to be a great place to enter long positions in the market because the early-March, early-April, and mid- to late-July VIX moves above 20.00 all preceded market advances.
However, the push above 20.00 in early December 1996 (which was also a great time to be long the market) defined the point where the VIX shifted higher out of its previous range. From then on, the new range was between approximately 20.00 and 25.00, so closes above 20.00 were no longer indications of excessive market pessimism.
Then in August and September of this year, the VIX again shifted higher, this time pushing up near 30.00. Currently, 30.00 is a round number above which the VIX signals excessive market pessimism that would most likely precede an advance. A recent example corroborates this theory.
Taking a long position in the S&P 500 Index (SPX) after the first close above 30.00 on 10/27 and holding it until it closed back below 30.00 would have been a very profitable one. In fact, the SPX rallied from 876.99 to 958.98 for a 9.3% advance over this period. Even though the VIX did not close above 30.00 on 12/12, it did push above there intraday. Now that we can see a market bottom was placed on that day, we might expect continued upside moves that typically follow the excessive pessimism illustrated by high VIX readings.
NASDAQ Advance/Decline Line
An Impending Bullish Signal
As our testing of a particular indicator evolves, our ability to utilize its predictability is often enhanced. One such example is how we compare the number of daily advancing and declining stocks. In the past, we considered it to be bullish when the 10-day moving average of the ratio of daily NYSE advancers to decliners exceeded 1.5. Here, we look at this indicator in a different way that produces much better results.
First, we determined that NASDAQ advancing and declining numbers are far better than using NYSE stocks alone, or NYSE and NASDAQ issues together. Second, we constructed a cumulative advance/decline (A/D) line since October 1972 by continually adding each day's net advance number (number of NASDAQ advancing stocks minus the number of declining NASDAQ stocks) to the previous day's total. This A/D line is then analyzed to predict intermediate- to longer-term performance. A bullish signal is generated in the following manner. First, we look for situations when the cumulative A/D line is lower today than it was 10 days ago. If we see a period in which this has been the case for at least 21 straight days, we then look for the end to these progressive declines that will mark the generation of the bullish signal. For example, Table 1 shows the relevant data from the most recent example of this bullish signal that occurred on May 2, 1997. The cumulative value on May 2 (—174,025) was greater than 10 trading days prior on April 18 (—174,291), the first such rise after more than 21 straight days of declines.
Table 1
Date Adv Dec Net Cumulative 4/16/97 1833 2085 —252 —174392 4/17/97 1969 1929 40 —174352 4/18/97 1966 1905 61 —174291 4/21/97 1468 2535 —1067 —175358 4/22/97 1823 2150 —327 —175685 4/23/97 1731 2122 —391 —176076 4/24/97 1940 1892 48 —176028 4/25/97 1697 2181 —484 —176512 4/28/97 1768 2066 —298 —176810 4/29/97 2330 1553 777 —176033 4/30/97 2101 1929 172 —175861 5/1/972 2151 7244 91 —175370 5/2/972 6771 3321 345 —174025
Since the 1987 crash, there have been 13-bullish signals that followed downtrends lasting from 21 to 62 days. Graph 2 compares the average OEX performance over the 60 trading days following these signals (line with the squares) with the S&P 100 Index (OEX) return at any time since October 1987 (straight dark line). One of these signals occurred in September 1990, in the midst of the Persian Gulf Crisis. As this was not a “typical” time for the market, we removed this example, resulting in somewhat greater post-signal performance, as shown in Graph 2 as the line with the triangles. The graph clearly shows moderate, consistent outperformance up to 60 trading days after the signal is generated. Of note are the returns generated 15 and 30 days after the signal; the OEX outperformed 85% and 92%, respectively, of the time following a bullish signal compared to the OEX at any time. While not as dramatic as some of our other indicators, we find the NASDAQ advance/decline line useful for confirming other bullish signals that point to intermediate- to long-term market outperformance.
As of Wednesday's close, the NASDAQ A/D line has been downtrending for the past 26 trading days. When this trend is broken to the upside, the bullish signal becomes active. Based upon recent A/D readings, we don't expect this to happen for two to three weeks, but investors should keep an eye on it.
What Normally Happens After the Market
Closes Lower All Five Days In A Week?
Last week, the market experienced an unpleasant phenomenon–the OEX closed lower on the day for all five days of the week. This is only the 21st time this has happened since 1976, or just a shade under once a year. Most investors' initial reaction to this uncommon occurrence, especially at the Friday close of one of these weeks, is probably panic and the desire to sell or turn bearish. Once again, we have found that when it comes to the stock market, crowd behavior rarely turns out to be correct.
This was a fairly simple study, structured in much the same way as the previous one. The bold line on Graph 3 represents the average at-any-time OEX weekly move and the line with the squares represents the average OEX move following the 20 previous occurrences of a full week of market declines.
An initial look at the results shows that market performance lags the average for eight to nine weeks. However, the study also shows that the market doesn't “underperform,” as the study results are, for the most part, not negative. The market merely moves sideways for about six weeks before resuming its usual uptrend. Therefore, initiating a bearish posture after these special weeks does not help since “the damage has already been done,” and the next likely move is not a continuation to the downside.
Since one of the 20 samples came just a week and a half before the '87 crash, we thought it might be interesting to see how the results of the remaining 19 samples would look without this example. The line with the triangles on Graph 3 shows the results.
It's easy to understand how the 1987 crash or the Gulf War crash could impact the study results. Instead of this signal holding the market to no net gains after six weeks, the results now show approximately the average return at any time. In other words, a week where all five days closed lower on the day has virtually no long-term effects, assuming we remove the one example that preceded the 1987 crash.
What lingers in people's minds (and rightly so) are memories of the losses suffered in the previous week's trading. One of the keys to successful trading is to not let those memories have an adverse impact on future trading decisions. This study is further evidence that being bearish at the beginning of this week due to the market performance of last week (Dec. 8-12) is not the correct call.
1997–The Stealth Bull Market
Let us share a secret with you–SPX is up 29.7% this year. That's more than twice the average return since the mid-1970's, more than last year's 20.3% rally, and nearly as much as the 34.2% advance of 1995. The funny thing is that this isn't front-page news. Perhaps that's because investors might not be participating in this rally. After all, only four out of the 25 wide-ranging sectors we track beat the SPX in November. No wonder fund managers have such a difficult time beating the market.
Another possibility is that investors have come to expect this kind of market performance. If this is the case, we shudder at the thought of 1998's performance. Such complacency is a very clear harbinger of depleted buying strength and a resounding signal of impending danger. It will be interesting to see what the “gurus” say about the possibilities of a fourth year in a row that ends at least 20% greater than where it started.
This brings up an interesting point about what was so encouraging at the end of 1996–virtually no one believed that 1997 would be a good year. Everyone had their reasons and they were all logically sound–inflation possibilities, slowing earnings growth, years ending in “7” are bad, years following Presidential elections are bad, years ending in “7” that follow Presidential elections are almost always bad, and the fact that three years in a row at greater than 20% is unbelievably infrequent. Certainly, these are all great points, but none of them mattered. It all came down to the fact that buying strength was greater than selling strength. By listening to the sentiment that surrounds the market and taking the opposite view, we can best position ourselves to ride the market down the path of least resistance. Keep a skeptical eye on the 1998 predictions that are sure to start cropping up soon and have a very profitable 1998.
Consensus Index of Bullish Market Opinion
By Consensus, Inc.–Kansas City
The 10-day moving average of the equity put/call ratio has moved back above 0.50 and appears to be headed for a triple-top. This situation is similar to when the ratio peaked the first time in March 1997, only to see it turn back up as the market continue lower. Only after a second p/c ratio peak in April 1997 did the market shoot back up. What is very encouraging this time is that when the p/c ratio peaked for the second time on November 26, the S&P 100 Index (OEX) was 5.94% higher than during the first peak on October 30. In other words, investors were still excessively pessimistic even though the market had been rallying very strongly for an entire month!
On a similar note, corresponding Consensus (Kansas City) Index of Bullish Market Opinion readings came in lower each time, 85 to 63 to 57. Each successive peak was met with less optimism (excessive levels of which equate to lack of buying strength) than the time before. It is only a matter of time before the lack of selling strength, as indicated by the increasing equity put/call ratio, becomes overwhelmed by the buying strength that is gradually seeping back into the market, as indicated by the Consensus numbers.
December 18, 1997 Michael J. Oyster
Investment Research Institute, Inc.
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