Technically Speaking, August 2007

Ryan Detrick, CMT, recently interviewed Bernie Schaeffer, Chairman and CEO of Schaeffer’s Investment Research, Inc. and author of Wiley Publishing’s The Option Advisor: Wealth-Building Techniques Using Equity and Index Options. He has edited the Option Advisor newsletter since its inception in 1981, and it has grown to be the nation’s leading options newsletter. In 1997, Bernie launched SchaeffersResearch.com, a four-time winner of Forbes “Best of the Web” award. The site has also been named the top options website by Barron’s and received positive mention in The Wall Street Journal Guide to Online Investing.

Bernie is widely recognized as an expert on equity and index options, investor sentiment and market timing. Timer Digest has been monitoring his work  since 1984 and ranks him as the #2 Gold Timer forthe past 10 years and the #3 Gold Timer for the past 5 years. Furthermore, among more than 100 of the nation’s top market timers, Bernie is rated as the #5 Bond Timer and the #9 Intermediate Market Timer for the last decade.

Ryan Detrick [RD]: Good afternoon Bernie, tell us a little about your background.

Bernie Schaeffer [BS]: My interest in the stock market was imprinted very early. I grew up in New York City, and as a boy my dad took me on several occasions to the visitor’s gallery at the New York Stock Exchange where I was able to look out over the trading floor. I found this fascinating, particularly when a stock got very active and big crowds gathered around its trading post, yelling and screaming their orders. It’s a shame they had to close this visitor’s gallery in the aftermath of 9/11.

I graduated from New York University with a degree in mathematics and I started my business career as an actuary, so I was pretty well steeped in statistical analysis. I moved to my current home town of Cincinnati to become a Vice President at a local property/ casualty insurance company. But this was around the time that listed equity options trading was starting to get popular, and the combination of my interest in the stock market and my love for quantified approaches proved irresistible and I knew I needed to get involved with options trading full time. I started the company that is now Schaeffer’s Investment Research in 1981 with a partner (Bob Bergen who has since retired) who was also an actuary.

When I’m not up to my eyeballs in the market I enjoy thoroughbred horse racing. I own a few race horses, and I can say that winning a horse race is even more of a thrill than cashing out a big winning trade!

RD: Going into 2007 you were one of the more bullish market strategists. Could you tell us what you liked heading into the year?

BS: Yes, I had the highest forecast for the Dow for 2007 among the 80 or so strategists in the poll from the year-end issue of BusinessWeek.

The Dow was flirting with an all-time high in May 2006 before retreating by 1000 points into the July bottom. This correction fell shy of the 10% decline so many felt the market “needed”, but I found the fear and loathing it generated as measured by such indicators as soaring volatility indices and climactic put activity to be off the charts and very bullish in its implications. The “euphoria” that had been attributed to the 2005-2006 rally was revealed to have been a sham – it was a mile wide and an inch deep. And the hangover from the negativity surrounding this mid-year correction stayed with us through the end of 2006, despite week after week of all-time Dow highs in the fourth quarter.

This juxtaposition of bearish sentiment against bullish price action is the most powerful possible buy signal in my world, as it establishes that there is sideline money (and short-covering impetus) to drive the market much higher than players expect. In essence, it gives you as a trader “permission” to go with the trend and with the price momentum. By year-end, I was convinced that the S&P would be next to achieve an all-time high, and that the 10%+ additional rally needed to accomplish this was very likely to occur in 2007.

RD: It appears sentiment plays a huge part of your overall market view. What do you look for regarding sentiment?

BS: It all comes down to how two factors: Getting an accurate read on sentiment and placing the sentiment in an accurate context, which means looking at the price action of the underlying asset.

I grew up as a trader in the world of listed equity options. I began by using options as a trading vehicle, but I soon realized there was a treasure trove of information contained in the option activity itself. Bullish activity in call options could be viewed separately from bearish activity in put options, and all this could be further sliced and diced by expiration month and strike price. Until the 1980’s when listed equity options became actively traded, determining the sentiment on the stock market was confined to analyzing what people were saying through the medium of various investor and advisor polls. But through the vehicle of options data, it became possible to look at sentiment through the lens of what people were actually doing through their put and call activity, and at the same time it became possible for the first time to look at sentiment on a stock-by-stock basis. These were huge breakthroughs for the capabilities of sentiment analysis.

Of course, it’s not all that simple to extract the sentiment information from the options data, as much of the activity is initiated by option sellers rather than option buyers and a growing portion represents hedging activity. But that’s part of the challenge and certainly part of the fun. 

The second factor – placing the sentiment in the proper context of price action – led me to the approach we at Schaeffer’s Investment Research now refer to as Expectational Analysis.

RD: Expectational Analysis. Could you tell us a little more on that?

BS: Sure. The traditional picture of the sentiment analyst is one that of the “contrarian curmudgeon”. If the crowd is bullish, the curmudgeon wants to fade that sentiment and be short. And bearish crowd sentiment is his cue to go long.

As we all know, this is not the way the world works, even if the curmudgeon has good tools for determining the sentiment. Bullish sentiment in the context of a bull market is what the old newspaper world used to call “dog bites man” – it’s not news because it’s not surprising and, in the context of what we do, it’s not tradable. The same goes for bearish sentiment in the context of a bear market. Sure, markets top when bullish sentiment reaches the “euphoria” stage and they bottom when bearish sentiment reaches the “panic” stage, but these extreme sentiment states are very difficult to measure precisely (euphoria can always become “mega-euphoria”) and there is a lot of money that can be lost before the last bull (or the last bear) is left standing.

So I’ve tried to focus over the years on the “man bites dog” situation in which the price action is out of synch with the sentiment. When a stock has a beautiful uptrending chart and is consistently making new highs and at the same time puts are being heavily accumulated and short interest is soaring and analysts are ignoring the company or are rating it “hold” or “sell” – this is what catches my attention in my quest for long plays. And when a stock’s price action is horrible but Wall Street says “buying opportunity” and the shorts are nowhere to be found and they’re playing the stock in the options world from the call side, I take notice of this situation for a potential short.

The bullish and bearish setups created by mismatches between price action and sentiment have a very logical foundation. Pure trend following can be dangerous, and so can fading the shorts. But when the short sellers and put buyers are betting heavily against the trend and they are continuing to be defeated as the stock rallies, this creates the potential for a rally that feeds on itself through the short covering mechanism. And when the analyst community has no enthusiasm for a strong stock, this indicates that substantial sideline money could come into play on analyst upgrades and initiations. Put it all together and I have a stock with a great chart but to which many players have yet to commit and on which there exists heavy short positions. So there is certainly the potential for a “virtuous circle” of further upside that begets short covering that then begets new money buyers as analysts capitulate that then begets further upside and so on. It happens time and again, and I want to be long as many of those situations as I can.

I distinguish “Expectational Analysis” from “sentiment analysis” because I’m looking at the sentiment only in the context of the technicals, and, to a much smaller extent, because I also apply a sentiment approach to the fundamental backdrop.

RD: What is your take on technical analysis and what type of charts do you use?

BS: In a broad sense, I think a “technical approach” is the only avenue for real success in trading, but there’s a wide swath of potential technical approaches. I personally have never had much success with “reading charts” in terms of price and volume patterns, though I know people who have that “sixth sense” of being able to look at a chart and envision how the price action is going to play out.

I believe my Expectational Analysis approach is almost purely technical, though there is also an element of attempting to read the sentiment through anecdotal tools like magazine covers. My use of charts is pretty much confined to establishing the context of my sentiment reads, so I’m basically looking for a chart to tell me whether a stock is in a clear uptrend or a clear downtrend. For this purpose I use conventional daily, weekly and monthly bar charts. I find moving averages to be my most important tool, and I also use pullbacks to moving averages as an important component of my entry regimen. I try to be a little unconventional in the moving averages I rely on, mostly in the sense of focusing on a larger number of moving average units than is commonly used on daily, weekly or monthly charts.

RD: You’ve said that the record amounts of short interest and put open interest “pre-sell” the market. Could you explain what you mean by that?

BS: The “short squeeze” phenomenon has been widely discussed with regard to stocks with heavy short interest, whereby continued buying pressure (often accompanying bullish news on the company) creates a covering stampede out of the crowded short trade that drives the stock even higher. What’s not often discussed is the normal day-to-day mechanics of a stock (or a market) that is heavily shorted.

This shorting activity is a source of steady selling pressure that tends to keep a lid on the upside. But on normal pullbacks, there is a  tendency for shorts to take something off the tableand this provides a bid that supports the stock. In other words, heavy shorting creates a “pre-sold” condition which under most circumstances keeps rallies in check and provides support on pullbacks. One of the reasons short-term market declines end in “V-type” recoveries (often intraday) is that index put buyers take some of their position off the table as their “delta” increases and this translates into short covering in the underlying index futures and ETF’s.

A more general result of the “pre-selling” phenomenon is to reduce the level of panic on market declines, as those already protected with puts or hedged with short positions are not only unlikely to add to the selling pressure but are actually likely to help stabilize the market by taking some profits by incrementally reducing their exposure.

RD: You use the VIX for timing the overall market. What exactly are you looking at?

BS: The CBOE Volatility Index (VIX) – which is a measure of the implied volatility level and thus of the degree of “expensiveness” of the S&P 500 index options – has made a rapid transition over the past decade from an obscure indicator of the level of fear in the options market (because implied volatility levels are usually driven by put buying) to a “headline indicator” that you’re more likely than not to hear mentioned during the trading day on financial TV. We all know the effectiveness of an indicator can suffer severely from over use as it loses most or all of its predictive power and becomes more of an indicator to watch because everyone else is watching it. And I think this is where the traditional “high VIX is bullish/low VIX is bearish” contrarian analysis now stands.

Fortunately, there are always creative ways to look at most indicators to at least attempt to stay ahead of the crowd, and I feel I’ve been pretty successful over the years at doing this with the VIX. For example, I’d suggest that the traditional view that the VIX is driven by put buyers deserves a rethink, as does the view that rising volatility implies a transition from a bull to a bear market environment. I regularly post my current thinking on the VIX in my SchaeffersResearch.com commentaries.

RD: For someone just entering the world of trading and investing, do you have any advice for them?

BS: Read and learn. And when you think you’ve read enough and learned enough, read and learn some more. Don’t rely on “gurus” to think for you. You must learn to think and act for yourself, based on a foundation of knowledge that can give you the quiet confidence needed for investing or trading success. This doesn’t mean you should avoid the opinions of others whom you respect; it simply means that the ultimate arbiter of your actions must be you.

RD: Is there anyone who has influenced you over the years? If so, how did he or she influence you?

BS: I would say my two biggest influences have been Humphrey Neill and Paul Macrae Montgomery.

Of course, Humphrey Neill is the author of classic work The Art of Contrary Thinking. I consider this book, first published in the 1950’s, to be the foundation for modern sentiment analysis. The two biggest revelations Neill’s work provided me (among many others) were:

1. Contrarianism is not a trading system whereby the sentiment of the crowd is constantly and mindlessly faded. We as technicians all know the ultimate fate of those who always fade the trend. Instead, contrarianism is defined by Neill as a “way of thinking critically”, whereby the analyst juxtaposes the prevailing sentiment (the “thesis”) against a directly opposing view (the “antithesis”) and attempts to develop the most logical view. It may be that the analyst comes down on the side of the antithesis, in which case he or she is adopting the contrarian view. But sometimes the thesis (trend following) makes the most sense and other times some melding of the opposing views (what Neill calls the “synthesis”) provides the best course.
2. Without an objective and quantified measure of crowd sentiment, the contrarian view just degenerates into whatever most suits the subjective beliefs of the analyst. We’ve all seen situations where there are divergent views on a market and everyone from all sides is claiming to be the contrarian. This perspective from Neill reinforced to me the extreme importance of having a foundation of good sentiment data, much of which I developed over the years from the options market.

Paul Macrae Montgomery is an analyst and money manager who for many years has published a weekly newsletter called Universal Economics, first under the auspices of Legg Mason and then independently. Paul is certainly an accomplished technician but that would be far too restrictive a description of his work. The best way I can describe him is as a student of behavior – whether it be the behavior of the markets or the behavior of we fallible humans who create the ebb and flow of the markets. His pioneering work, for example, on the contrarian significance of magazine covers for stocks and the financial markets made a huge impression on me over the years. He also does a lot of great work with cycles – an area that’s  entirely outside my own toolbox.

RD: Do you have a favorite investing book or books you’d suggest we read?

BS: Certainly at the top of the list would be The Art of Contrary Thinking by Humphrey Neill, which is still in print.

I’m a big fan of works that were written in the 1920’s and 1930’s, as this was an era that spawned some great investing minds and also encompassed a powerful bull market followed by the worst bear market ever. My favorites in this genre are The Battle for Investment Survival by Gerald Loeb and Technical Analysis and Stock Market Profits by Richard Schabacker. 

Fast forwarding to 2007, I’m a big fan of Nassim Taleb’s books that explain the role of randomness, luck and rare events in investing – Fooled by Randomness and The Black Swan.

RD: What’s the one best piece of advice you could give someone involved in the market?

BS: Always keep a cash reserve that’s sufficient to tide you through the inevitable rough periods and allow you to take advantage of the opportunities that arise. Nothing is worse than blowing your trading capital, but a close second is being so fully invested that you are unable to take advantage of what you know could be a huge profit opportunity that might disappear tomorrow or even in the next hour.

That said about capital preservation and cash management, I also suggest concentrating your portfolio in what are truly your best ideas, as opposed to over-diversifying and thus potentially diluting your trading edge. The big money is almost always made through heavy exposure to high conviction positions. I think over-diversification is often a refuge for those whose trading edge is questionable or perhaps non-existent.

Of course, if you’re an option buyer and you’re risking a total loss on each position there is an advantage to diversification and higher risk associated with concentration. But even in that space, you can control your risk through a much higher cash position, and your best ideas should still garner significant extra exposure. There is also the mechanism of strike price and expiration date to control and fine tune the risk level of your option positions.

It’s all about achieving the proper balance between being able to live to fight another day if you’re wrong and being in a position to make big money if you’re right.

RD: We’ve read that there are some similarities between 2007 and 1987. What’s your take?

BS: Other than both years ending in “7”? A highly respected strategist did discuss some analogies to 1987 in a recent national media interview. He maintained there was a big equity shrink going on back then, as now, and the market was also supported by buying from overseas, at that time from Japan. And the Fed was not being accommodative – it was raising rates – and the dollar was also weak.

But I see some huge differences that tell me that “2007 is no 1987”. For one thing, we’ve got a pre-sold market (per our earlier discussion in this interview) that has a strong tendency to be supported on pullbacks. Back then “portfolio insurance” or dynamic hedging was the rage, whereby people had concluded they did not need to hedge or buy puts in advance of a market decline – they would instead buy their protection when and if the market weakened and would add to that protection on further weakness. Of course, the net result of the dynamic hedging mentality was an exacerbation of market weakness as everyone scrambled for protection at the same time. Continuing on the option side of the ledger, in 1987 there was a huge bubble in selling put premium, especially on the S&P 100 Index (OEX). It was believed that put selling was a form of minting money, as the market would keep rising for years to come. Of course, these put sales wiped out many traders in the October decline and exacerbated the crash. In marked contrast, these days there is still a major put trade in buying crash protection.

I also recall tremendous complacency on the pullback from the August 1987 top (as opposed to the “sky is falling” mentality such pullbacks now produce) and long-term interest rates back then were nearly double current rate levels. 

RD: What are you expecting for the rest of this year? 

BS: I’m expecting more of the same, which means more record highs.

This market has overcome some huge headwinds this year – not just the “wall of worry” about the subprime mess, the housing slump,  rising long-term interest rates, dollar weakness andrising gas prices – but headwinds related to record levels of  short interest, record put open interest and the fact that John Q. Fund Investor has forgotten about the US stock market and is investing more than 75% of his new money overseas.

A capitulation by the shorts or a shift in fund flows into the domestic US market could result in a market “melt-up”. Of course, the market becomes much more vulnerable should that occur, but we can cross that bridge when we come to it!

RD: Any final thoughts? 

BS: For those who found value in the concepts I discussed in this interview, I’d like to mention that I have a chapter called “Options-Based Technical Indicators for Stock Trading” in a new Bloomberg Press book entitled Breakthroughs in Technical Analysis to be published later this year.

Editors note: This book is scheduled to be released in September and is edited by MTA Member David Keller, CMT

RD: Thanks Bernie. It’s been a pleasure.