Tuesday, March 20, 2007

Euphoria, Panic, And The Stock Market: The Lesson Of The Recent Market Decline

There are few hard and fast rules in the stock market, but this one is a candidate: The market doesn't reward euphoria or panic.

I recently mentioned that bearish sentiment, as assessed by the equity option volume data, was at a higher level than at any time during the 2000-2003 bear market. Carry trade fears, combined with concerns over mortgage lending defaults, raised the 20-day equity put/call ratio above 1.0, something we hadn't seen in many years.

By the time we hit an intraday low in the S&P 500 Index on March 14th, fears were high--the VIX spiked above 21; put volume hit its highest level since the 27th, exceeding call volume by about 20%--but a number of things had changed beneath the surface:

* We were unable to make new lows in the Russell 2000 Index;

* The number of stocks making fresh 20 day lows dropped to 1894 from 3274 on March 5th;

* The number of stocks trading below their 20-day moving average envelopes dropped to 875 from 2021 on February 27th;

* Dollar volume flows in S&P stocks had reached normal levels.

In other words, stocks had stopped responding to the panicky sentiment.

I just took a look at the 40 S&P stocks that I use to track eight market sectors. Only six are trading below their February 27th lows. Thirty four out of forty are trading above that level. Those who sold in panic on the 27th--and especially thereafter--are most likely underwater.

When extreme market sentiment lags the actual behavior of stocks, you can fade that sentiment profitably. That's the lesson of the recent market decline.