Studying the Dumb Money

When fear is running high among the dumb money, the Short Interest Ratio—NYSE (detrended) will be near or exceeding 0.2. As Figure 9.1

SHORT INTEREST RATIO - MYSE fDE-TRENDEDt wsrupdated May ?i. 2007

SHORT INTEREST RATIO - MYSE fDE-TRENDEDt wsrupdated May ?i. 2007

Copyright ?Q07, Ali ftlghis Reserved www.senlinwn7roder.coni Inverse sc j le

11990 11991 |1992 |1993 11994 11995 fl996 |1997 ¡IMB 11999 ¡2000 |20C 1 |2002 |2003 |2MJ |200E |2006 |2007

FIGURE 9.1 Short Interest Ratio—NYSE (Detrended) Chart Showing Correlation with Major Market Lows Source: Chart courtesy of SentimenTrader.com.

Copyright ?Q07, Ali ftlghis Reserved www.senlinwn7roder.coni Inverse sc j le

11990 11991 |1992 |1993 11994 11995 fl996 |1997 ¡IMB 11999 ¡2000 |20C 1 |2002 |2003 |2MJ |200E |2006 |2007

FIGURE 9.1 Short Interest Ratio—NYSE (Detrended) Chart Showing Correlation with Major Market Lows Source: Chart courtesy of SentimenTrader.com.

shows, a reading at that level indicates that the market may be near a major low. Conversely, when the dumb money is showing signs of extreme confidence, then this ratio will be near — 0.2 and possibly near a major high in the market.

Every trader knows that a major low in the markets was made in 2002. Returning from your sabbatical in mid-2002, however, you don't have that knowledge as yet. What you notice at this point is that the Short Interest Ratio—NYSE (detrended) was near 0.2, which is an area where major lows have occurred. This implies that the NYSE is nearing a major low. Therefore, instead of fearing that the market may continue lower, your confidence for a major bottom in the market is increasing.

The next sentiment indicator is useful in a shorter-term time frame; that is, the Rydex Cash Flow Ratio. As I explained in Chapter 7, Rydex is a mutual fund company that has both bullish and bearish funds for the S&P 500 and Nasdaq Composite. It publishes the total dollar amount of assets in each fund on a daily basis, which makes it possible to analyze sentiment based upon investors' cash flow into and out of the bullish and bearish funds. Therefore, we will be able to identify extreme sentiment among the dumb money investors on a shorter-term timeframe using the Rydex Cash Flow Ratio.

In Figure 9.2 ' the S&P 500 is in the top half of the graph, and the Rydex Cash Flow Ratio is on the bottom. Prior to 2003, Rydex funds had relatively small amounts of cash and were subject to extreme movement in either direction. Nonetheless, this ratio still gave a good indication of oversold levels when the ratio neared 0.75.

The Rydex Cash Flow Ratio shows that the dumb money flow into bearish funds in mid- to late 2002 was at an extreme compared to the money flow into bullish funds. This is another indication that the market was about to reverse to the upside. Looking ahead, notice that in early 2003 the Rydex Cash Flow Ratio hit a new three-year oversold level near 1.05, and in our view was a capitulation in that there was an extreme cash flow move to bearish fund. This was a very bullish sentiment reading and implied a major move up in the market was about to begin. Since 2003, this level in the Rydex Cash Flow Ratio has marked intermediate-Ierm lows in the market.

FIGURE 9.2 S&P Market Action Compared with Rydex Cash Flow Ratio Source: Chart courtesy of DecisionPoint.com.

Now let's review for a moment: We know that, as of mid-2002, Short Interest Ratio—NYSE (detrended), which encompasses a longer-t erm view of the market, reached a bullish level. By early 2003 the Rydex Cash Flow Ratio (which provides an intermediate-term view of the market) hit capitulation, which sentiment-wise predicted a significant bottom. Therefore, between midt2002 and early 2003, the sentiment on the larger time frame and intermediate-term time frame were very bullish.

There is another indicator that I would like to present, which is not a sentiment gauge per se, but it does reveal some interesting insights regarding whether the market is "sold out." Looking at Figure 9.3, we can see the percentage of NYSE stocks that were above their 200-day, 50-day and 20tday exponential moving averages (EMAs). This percentage helps to pick out major lows in the market that can sometimes last for years. This indicator does not need to be checked every day, but it is helpful to know where the percentage is at any given time.

We know that when a stock is above its 200- day, 50- day or 20- day EMA, it is trending upward and considered bullish for those time frames. A good way to determine if overall market conditions are overbought or oversold across a range of time frames is to analyze the percentage of stocks that are above their 200-, 50-, and 200-day EMA. We like to monitor the 200-day EMA to pick out significant lows in the market.

In Figure 9.3 , the top window displays the NYSE going back to 1987 and the window below is a chart of the stocks in the NYSE that are above their 200-day EMA. During periods of time when only 20 percent of stocks are above their 200-day EMA, the market is oversold, based on bigger time frames, and near a major low. This indicator has helped pick out all the significant lows going back to 1987, and is a good gauge to keep in your bag of technical tools.

Notice that we have started with the longer-term indicators, working down to the shorter-term ones. This is because the longer-term rules over the shorter-term. Therefore, once we have identified the longer-term trend, we align our short-term indicators to that trend. That way we have "stacked the cards" in our favor and have increased our chances for success in the market. We are effectively pursuing the adage of "buying low and selling high."

Thus far, we have determined that sentiment on the longer-term and intermediate-term time frames were bullish and we suspect that—this being mid- to late 2002 in our scenario—a low was being put in. And the percentage of NYSE stocks above their 200-day EMA at an oversold level of below 20 percent, which is also bullish.

Percent af HYSE Slocks Above Their 200/50/20 EMA Long-Term to 2007 DaasitmPant-Ctim

Percent af HYSE Slocks Above Their 200/50/20 EMA Long-Term to 2007 DaasitmPant-Ctim

37 53 6S flD el 92 ei 94 95 BO 97 9$ 00 Ot 02 03 04 05 00 07
FIGURE 9.3 Charts Showing Percentage of NYSE Stocks above Their 200-, 50-, and 20-Day Exponential Moving Averages Source: Chart courtesy of DecisionPoint.com.

STEP 2: EVALUATING BREADTH, VOLUME, AND MOMENTUM

The next step begins the top-down approach to the market by evaluating breadth, volume, and momentum. By evaluating these three factors our goal is to identify a trigger to enter the market.

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