Prepared by

Investment Research Institute, Inc.

In this issue of Schaeffer's Research Review, we will revisit some studies documented in prior issues. Several of the indicators mentioned have predicted significant moves in the market. Periodically, we will update you on the effectiveness of the indicators so only the best performers are used, and any ineffective indicators are discarded. Also in this issue, we will take a different look at the Consensus Index of Bullish Market Opinion for stock index futures, which is particularly relevant today. Also, we will explore the seasonality associated with the Labor Day holiday.

As long-time readers know, we frequently discuss the sentiment data produced by Consensus, Inc. of Kansas City. Their Consensus Index of Bullish Market Opinion of stock index futures traders has particularly telling implications for stocks. High readings suggest excessive optimism, which typically occurs when buying strength has been tapped out, and low readings represent depleted selling strength, and tend to precede market rallies. This week's near-record Consensus reading of 85% bullish has pushed the 5-week weighted average above 80% for the first time ever. This has sent many followers of the sentiment indicator running for cover and calling for impending doom. However, our research shows extremely high readings, while slightly bearish, are not as powerful as their extremely low counterparts.

Before this latest surge above 70%, there were 25 previous occurrences when the 5-week weighted average of the Consensus Index of Bullish Market Opinion of stock index futures traders was above that mark. For the first two weeks after such a reading, the OEX underperforms the average, even posting slightly negative returns on average. Between weeks three and six, average performance picks up and gradually starts to catch the at-any-time benchmark. However, it then seems to take a nosedive at week seven that continues for the following week.

Let us not be too hasty in declaring this an intermediate-term bearish indicator. A closer look at the numbers reveals that a single outlier is responsible for this distortion. There were two signals generated, one seven weeks and one eight weeks prior to the infamous 1987 crash. This effect is so extreme that one single reading out of 25 was enough to change the interpretation of the results. Without the data from the 1987 crash, the difference is rather dramatic. Instead of posting significantly negative returns, market action following such a signal begins up a steeper slope after week 7 and continues its rapid ascent through week 10.

With the current Consensus reading above 80%, it is less likely that we will experience one of the huge breakouts that the public has become so accustomed to in past years. In fact, this excessive optimism was a large part of the reason we moved away from our bullish stock market posture that had been uninterrupted over the last year and a half. When the Consensus numbers start to come back down, and eventually they will, we will not hesitate to reclaim our bullish posture.

This time last year, we studied a sentiment indicator tracked by Michael Burke with Investor's Intelligence. Investor's Intelligence polls newsletter writers as to their opinion regarding the stock market. It is a relatively rare occurrence when the bearish outnumber the bullish, and when the reading switches back to more bulls than bears, the market typically follows with a rally.

Last year, the August 15th Schaeffer's Research Review mentioned that such a bullish signal had been generated on August 9th. In the first 25 trading days following that reading, the OEX rallied by more than 3.2%. Another cross of the percentage of bulls back above that of the bears occurred on May 16th of this year. The OEX rallied by more than 7.6% over the 25 trading days that followed that signal. As of today, the percentage of bulls is much greater than that of bears, so no bullish crossover will take place for quite some time. Yet this sentiment indicator is certainly one worth tracking, considering the research documented in a prior issue of Schaeffer's Research Review and the two readings that followed.

In the November 1996 issue of Schaeffer's Research Review, we mentioned that instinctively, it might seem logical for a substantial move higher in the OEX to be followed by a pullback. In fact, this was shown not to be the case.

In the days that follow points where the OEX is more than 6% greater than its 50-day moving average, the OEX tends to follow through with a rally rather than stall out or reverse. The most recent occurrence of this was on May 5th, and the OEX posted more than a 3% rally over the ensuing 25 trading days. Not only did the market avoid reversing lower after a significant advance, it actually (in this case) posted a rally well above what the OEX averages for the same number of days at any time. The OEX has now dropped to a point only 0.84% above its 50-day moving average, but eventually the OEX will enjoy another rally pushing it well above its 50-day. When this occurs, there will be no reason to fear a major decline based simply upon the fact that the OEX will have rallied substantially and might then be considered “overbought.”

The art of observing investor psychology is one in that we continually strive to build upon and improve. Indeed, with every holiday that comes and goes, it is interesting to note its effect on the market. As Labor Day quickly approaches, the ability to anticipate how the crowd reacts may keep you one step ahead as investor behavior tends to repeat over time.

For the investor who is concerned about events that change the market, we conducted a study to identify investor behavior around Labor Days from 1983 through 1996. Using daily data, we examined market activity for the 10 days before and after Labor Day. The results showed that, on average, the market increases for the 10 days prior to the holiday, but tends to decline for the 10 days following Labor Day.

In particular, the data shows that in the 10 days before Labor Day, the market typically moves an average of 0.54%. This is just slightly higher than an average 10-day OEX move at any given time during the year (0.51%). Despite this performance, the Thursday before Labor Day has the highest single-day negative reading of the 20-day period, at —0.42%.

In the 10 days following Labor Day, the market tends to stall out and decline as the OEX averages —0.22%. Not a significant decline, but a decline nonetheless. Consequently, if you anticipate pulling out of the market around the holiday, it is best not to wait until just before the weekend.

In 1990, Labor Day fell shortly after Saddam Hussein's ground campaign against Kuwait. As you are aware, the war had an incredibly adverse effect on the market, thereby distorting the “typical” Labor Day readings. To make the study more accurate, we removed the 1990 data to determine if the 1990 data skewed our results. Generally speaking, the results were the same. On average, the market increases for the 10 days prior to the holiday (again showing the worst performance on the Thursday before Labor Day weekend), but tends to decline for the 10 days following. The only difference is how much. Without the 1990 data, the OEX gained an average 0.67% prior to Labor Day. This is 0.16% higher than the average 10-day OEX move at any time during the year. In the days following Labor Day, the OEX falls only 0.14%, on average. As a result, any positive market performance normally occurs prior to the holiday.

Mike Oyster, Jerry Wang and John Colligan

Since last month's issue, the Consensus readings have come in even higher. This recent push above 80% (for the 5-week weighted average) and the technical failure of the OEX's 20-day moving average have prompted headlines of “10% correction” and “end of bull run.” Our research in the main section does indeed suggest that market performance stalls for a few weeks following these signals. But by no means does it suggest even an intermediate-term top. In fact, when the previous high Consensus readings were recorded back in May 1989, the market stalled (not declined) for six weeks before gaining 9% over the next month. Currently, the OEX has reached the level that it was back on July 3rd, exactly six weeks ago. While it is possible for the market's recent poor performance to continue for another week or two, it is more likely that this week's pullback will eventually act as a springboard for future gains.

In the midst of all this “excessive optimism” that is supposed to be hanging around in the market recently, there are two indicators that suggest otherwise. On August 8th and 13th, the CBOE equity put/call ratio broke its upper Bollinger band. We showed in SRR volume 2, issue 6 that this has bullish implications in the intermediate- term. Although the public buys calls with dreams of returns akin to those of the past two years, their fear sends them flocking to puts at even the slightest sign of weakness.

Another indicator that has revealed the public's fear is the VIX. We had two spikes recently, on July 18th and August 13th, that rivaled those seen at the pit of July 1996's correction. When the VIX came back down from that extreme spike, the market experienced a huge rally for the rest of the month. The high put volume and high volatilities suggest that the public is buying puts. Once again, this extreme fear and anticipation (fear of nothing other than that the good times might end) is exactly what feeds the market and keeps it growing.

Jerry Wang

August 14, 1997 Investment Research Institute

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Consensus National Futures and Financial On Line Index
Financial Commentary Index

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