Note: See important disclaimers below article.

Just as there are bubbles of positive sentiment (ie. Manias), there are also bubbles of negative sentiment (ie. Panic) where investors generally believe the end of the world is near and the last thing they want to be caught doing is holding stocks. This, I believe, was the situation in the early days of March 2009, just before the market bottomed.

The situation has definitely improved much since then, but has it improved for the right reasons? Should investors still be bearish? In this second edition, I explore the biggest justifications held out by the “bears”.

Top 5 reasons to be BEARISH

“What’s with the insiders?”

Insiders are those people who have access to non-public information about a company – ie. Employees, senior management, executives. In recent months, insider selling has FAR outweighed insider buying by many multiples. With figures courtesy of TrimTabs (which tracks insider transactions), during August, insiders averaged $210 million worth of shares bought, while they sold $6.3 billion worth. That’s a whopping 30x sell-to-buy ratio! In the last week of August alone, there were $8 million worth of insider buys corresponding to $520 million of insider sales. That means a ratio of nearly 62x! If insiders are selling, and they know more than the market, then what does that show?

“Where is the volume?” ­

One of the cornerstones of trading wisdom is to follow the volume. Some go so far as to say that a trend holds little meaning if it is not on rising volume. For the rally starting in March, the volume, unfortunately, peaked in March as well. A look at the chart below shows that the ride up has been on declining volume. This makes the rally technically “un-sound”. Even in daily trading, dips have been on high volume, while gains have been on below average volume. And volume usually supports the “correct” trend.

“Show me the money (ie. Revenues)”

While analysts have rejoiced over earnings beats during both Q1 and Q2, the fact is that the beats have been on the bottom-line (ie. Net Income). Companies have had smaller losses than expected, but these have been the result of aggressive cost-cutting, instead of better than expected revenue numbers. Such cost-cutting is not a sustainable solution to maintain better than expected profitability. What’s necessary is revenue improvement which can only result from demand returning to the fore. This has so far not been seen and it remains unclear when it might return as the savings rate in the US shoots up towards 10%, unemployment continues to rise and businesses hold back on investments.

“Rally is stimulus driven” ­

The start of the March rally coincided with some of the largest aid programs initiated by the US Treasury and the Fed. For example, the Public-Private Investment Program (PPIP) and the American Recovery and Reinvestment Act, initiated by Barrack Obama, both came into play during March. As such, it is easy to postulate that the market rally is the result of excess liquidity provided being channelled into the markets. Following from that, when these temporary programs and government guarantees are rolled back in, the un-natural support for the equity markets might evaporate overnight. Already, the markets have seen a negative impact on the car manufacturers as the cash-for-clunkers program ended with US car sales declining 41% month-on-month in September. With a massively increasing US debt burden, other government programs cannot continue indefinitely.

“It’s all those computers”

Program trading makes up about 70% of the trading volume on the NYSE. Program trading refers to the high-frequency trading that takes place between computers which take advantage of things like liquidity rebates offered by the exchanges, co-location benefits etc. Program trading is rarely motivated by company fundamentals, which leads to the question of whether the direction of the market is even related to fundamentals, since program trading accounts for such a large proportion of trading. In recent weeks, the effect of such trading has been quite obvious with trading in just 5 stocks – Citigroup, Bank of America, AIG, Fannie Mae and CIT – making up roughly 40% of the total NYSE daily volume. This is very unusual, even ignoring the fact that 3 of those 5 companies are already bankrupt. And on several days, the shares of even long defunct Lehman Brothers, were bid up causing them to triple in a few days, showing the huge disconnect with fundamentals again.

Toss a coin?

Where the rally goes from here is anyone’s call. It’s relatively easy to identify the factors that play into setting the direction of a market but close to impossible to ascertain the magnitude of the impact that each will have in determining what that direction is.

Whether it’s a bear-market rally or a new bull-market, a minor bubble in a largely imploding market or a new bubble all together, the goal would be to understand the dynamics either way and take advantage of them. Unfortunately for us, we can’t use the “heads I win, tails you lose” formula.

Disclosure: Long the market

Image credit: Jenny Downing

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Until Friday.

On Friday, the markets purged. Or, in a more business savvy term, they capitulated, which means that sellers decided to finally and fully give up on previous gains (or losses) as a final effort to get out of the market to less risky investments. In other words, the bears have all finished selling, and the last seller has sold, so now the bulls will start buying. Whereas in the last few weeks, we have seen stocks decline towards the end of the day as people get rid of their investments to avoid overnight surprises, market capitulation is characterized by very high trading volumes which occur early in the day, which we saw on Friday. The Dow went as low as 7,882 on Friday (loss of nearly 8%) before closing at 8,451.

Based on a CNBC article, about 3B shares traded hands Friday, which may very likely be the volume to achieve the long-awaited capitulation point. You can bet many traders sighed in relief at 4:00. Is this turnaround going to sustain? Jim Cramer didn’t think so, and believed that today would mimic the renowned, Black Monday. Take a look here.

Jim was obviously wrong as the markets are rallying today.