Bullish Signs in a Bearish World

08/06/2008 12:00 am EST

Focus: MARKETS

Joe Sunderman

Vice President of Research and Development, Schaeffer's Investment Research

Joseph Sunderman of Schaeffer’s Investment Research, writing in the Option Advisor, says the bears still rule, but there are slivers of hope for the bulls.

The backdrop of weak performance has rallied the bears collectively to levels not seen in years (almost two decades). Bearish sentiment has gripped all investment types—from professionals to newsletter editors to individual investors. It is not hard to find a card-carrying member of the bear camp these days.

A Merrill Lynch survey of global fund managers has current sentiment toward equities as more negative than the period between from 2000 and 2003 (when markets were much weaker). As represented by Investors Intelligencepoll, newsletter editors are having their own bear convention. The release of the survey on July 16th saw the bullish percentage at 27.8% and the bearish percentage at 48.9%. The net difference of bulls and bears (-21.1%) was the lowest figure since December 1994.

Individual investors are similarly pessimistic. The American Association of Individual Investors recorded three consecutive weeks of readings at or below 25% (July 3-July 17). This has not occurred since February 2003, leading up to the war in Iraq under George W. Bush.

Amid the rally off mid-July’s lows, we have seen some encouraging developments for the bulls beyond all the negative sentiment.

First, Public Enemy Number One—oil—has declined approximately 20% off its highs. Second, despite second-quarter earnings being completely written off (before even being announced), the results (thus far) are not as bad as what was expected. As of July 21, positive surprises were leading disappointments by a 2.9-to-1 ratio, in line with recent historical norms, according to Zacks Research.

Finally, we continue to see the federal government assist a tumultuous financial market (i.e. Bear Stearns, Fannie Mae, and Freddie Mac). This has reassured investors that the Feds are not standing idly by. Despite all the turmoil during the past two months, option players are being given an unbelievable opportunity. High stock volatility and low implied volatility is the ideal backdrop for option premium buyers.

Stock volatility is in the forefront of traders’ minds these days. We are in the middle of the earnings season, which is a very volatile period for individual equities. Also, with the Standard & Poor’s 500 only 4% to 6% off its lows, short-term volatility will likely remain high.

The market’s proxy for implied volatility is the CBOE Market Volatility Index (VIX). The VIX has dropped 27% since its intraday high on July 15th. The current VIX reading is lower than 67% of all the readings for the past year. Such VIX readings reflect an options market that is trading at a discount in an environment when the premiums have extra juice priced in them.

Though the environment is ripe for the premium buyer, this is not to say that “slam dunks” are plentiful. Volatility will be swift for both the bulls and the bears.

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