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Crash or Shakeout - Sentiment Extreme

As a followup to the previous post on why the market correction during December 2021 seems to be a shakeout and not a crash, the recent developments need to be added into perspective. If you haven't read the earlier article yet, you can read it here. That would set the context to why the downturn in December didn't feel like a crash. And despite the recent volatility, it still isn't! Nifty dropped to 16410 on December 20th. More than a month later, we are yet to break lower even with all the panic created by US markets ahead of the FOMC meet, FII outflows and fear-inducing media handles.


The premise is simple, traders have become even more bearish than last time I put out the post. Extreme sentiment indicators have started flowing in and sheer amount of data that's pouring in. which is indicative of too much shorts in the system, is simply stunning. Checkout each of them.


Lowest Nasdaq Stock Exposure Since 2019 By Stock Market Timers
Lowest Nasdaq Stock Exposure Since 2019 | Source: www.HulbertRatings.com

Above is the average stock market exposure of market timers (Speculative traders) on Nasdaq. This was lower than March 2020.


Next one is the Advance-Decline ratio of stocks on NYSE composite. It was -293 on Jan 21, 2022 with the deepest during the 2020 crash being -421. And this is at a time when the market hardly corrected by 10% in past few days.


NYSE Composite Advance-Decline Ratio
NYSE Composite Advance-Decline Ratio | Source: @McClellanOsc

Next is the CBOE Put Call Ratio, at the highest level since the 2020 crash. This is indicative of the too much PUTs being bought my traders expecting to benefit out of market fall.


S&P 500 PCR Ratio
S&P 500 PCR Ratio | Source: @McClellanOsc

Next. This one is similar to the PCR, but it's the overall PUT volumes by market players. Again highest since March 2020, hitting 2 million. This again indicates retail players buying PUTs while players with deep pockets writing PUTs. A contrarian indicator.


S&P 500 PUT Option Volume
S&P 500 PUT Option Volume | Source: Bloomberg

Next. More than 85% of Nasdaq QQQ stocks were in a correction. This level of underperformance has led to a bounce everytime except 2002 & 2008. The data just keeps coming.


Nasdaq 100 Stocks In Correction
Nasdaq 100 Stocks In Correction | Source: @sentimentrader

Next. AAII (American Association of Individual Investors) survey data. % bears near all time highs, top 2.2% in history. At a similar level to March 2020. Also the Bull-Bear spread at it's extreme that are only seen during recessions and big stock market crashes.


AAII Survey Data
AAII Survey Data | Source: @macrocharts

Again it's necessary to remind that all these extreme sentiment and short position indicators have come at a time the market has corrected only about 10%. These are significant contrarian indicators.


Though all these data are on the US markets, this has a significant influence over the Indian markets due to a correlated rub-off on all global markets. Global markets are more tied to each other due to globalization than ever before and it doesn't take long for traders to carryover sentiments across markets.


Take the recent downfall in Indian markets, it has got more to do with external factors then domestic factors. Inflation has been benign, RBI still haven't announced a rate hike and maintained a stance that they will keep an accommodative outlook. Corporate earnings have been largely good in the last quarter and the 2022 budget is widely expected to be neutral with increased fiscal spending to boost the domestic economy. Yet the market fell. A clear indication that global news flows are dominating market moves.


The negative sentiments in the domestic market are quite visible too through social media platforms and the general discourse in it. Especially on twitter where I skim through. Twitter has turned into sort of a hub for trade recommendations and the general theme nowadays is "short the market". The speculative narrative of Option writers is visible on the positional data on NSE as well. As of this Friday, 28th Jan, PCR stood at 0.6 for next week and 0.4 for the week after! Option writers who are short on the market are at an extreme. With India VIX hitting 25 this week before coming off to 20, "Panic" & "Short" are the loudest words in the market.


Historically, such bearishness had always led to a recovery, including March 2020. Of Course this time could be different, but I would rather lean on a proven track record.


Lastly I need to talk about the recently concluded Fed meet & Fed Chair Powell's comments to put things into context. Let me make it clear that there were no concrete plans provided on the rate hikes. Yes, its planned to start soon, but Fed Chair Powell never gave a definitive answer to any of the questions. How many rate hikes, when it's starting, what's the quantum of rate hikes, none were revealed. In fact he even mentioned that discussion is still happening on it. Moreover, the actual FOMC policy statement was different from the narrative on the press conference, a fact that was attested by the US market movements. US indices were rallying after the FOMC statement was released, but plunged during Fed Chair Powell's press conference, indicating uncertainty. The narrative from the press conference could be due to the political pressure coming from the Congress as President Biden put the blame squarely on the Fed Chairman and said the responsibility lies with the Fed to reign in inflation. Democrats need to a face a mid term election in 2 years and hence the pressure to get inflation under control. So the policy narration seems to be pushed politically, rather than the actual distress of inflation itself. If inflation was the real concern, Fed should have raised rates at-least in this meet, if not much earlier!


With that understanding, if CPI numbers starts to climb down due to higher base effects of last year, that could be construed as a positive to not raise rates aggressively as market is expecting. Markets currently expects more than 5 rate hikes within an year. But, if Fed softens it's stand based on falling CPI print, the markets which is already in a crazy, irrational bull market, doesn't take long to reverse the losses to scale new highs. Any such sentiment reversal could be a push towards a melt-up in financial markets lead by Euphoria.


To sum it up, of course the markets carry huge risk, but the risks might not play out as soon as everyone thinks, due to the extremely bearish sentiments. Rather the risks play out later when the inflation, sticky as it is, forces the Fed's hand to commit a policy error. And risks get realised when majority are super bullish and now the sentiment is quite opposite.


PS: Technical indicators in major index SPX, NDX, DJIA, Russell 2000 for US & Nifty for India are favouring a pullback rally. Please check my twitter handle @getfinsight for more details on it and also for more frequent commentary on market happenings. I intended to write this article earlier, but couldn't find the time to do it until now. Twitter seems to be an easy way to put thoughts in short, crisp posts quickly.


You can follow me over twitter on https://twitter.com/getfinsight


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