Option Advistor

The following is a reprint of the market commentary from the April edition of the Option Advisor, published on March 28. Prices and the chart are as of the close on March 28. For more information or to subscribe to the Option Advisor, click here.

A common phrase that parents tell their children is "You can't judge a book by its cover." In other words, you should look deeper before judging something. This idiom can be applied to one of our classic qualitative sentiment measures - magazine cover stories. Judging by the magazine cover stories during the past few weeks, one will realize that the media has given roughly the same degree of coverage to the events roiling Wall Street as they have to every utterance from the Democratic hopefuls. In fact, during the past 2 months, approximately 9 market-related cover stories have graced the jackets of 5 major publications - all with a consistent bearish tone. From BusinessWeek to The Economist and from Fortune to Newsweek, we have seen rampant concerns regarding the stock market's volatility, looming economic recession, stifling credit market crunch, and systemic problems of Wall Street. The list below summarizes some of the recent covers related to the market.

3/31/2008 "Reluctant Revolutionary" - Special Report "The Financial Crisis"
3/24/2008 - "Waking up to the Recession"
3/22/2008 - "Wall Street" - (image of broken street)
2/28/2008 - "Credit on the Edge"
2/18/2008 - "Now What"
2/04/2008 - "Road to Recession"
1/26/2008 - "It's Rough Out There"

Magazine cover stories have been important at key market bottoms throughout the past 30 years. Some of the titles are now considered classic contrarian signals - "Recession Greetings" (1974), "The Death of Equities" (1978) , "The Crash" (1987), "High Anxiety" (1990), "The Economy: Is there light at the end of the tunnel?" (1992), "How To Survive A Scary Market" (1994), "Jitters" (1996), "How Worried Should You Be?" (1998), "America's Bubble Economy" (1998), "Grin and Bear It" (1998), "Trapped: Alan Greenspan's bubble nightmare" (1999), "The Angry Market" (2002), "Whipsawed by Wall Street" (2003), and "Which Way is Wall Street?" (2006).

We have never seen such an onslaught of negative cover stories in all our years of tracking the market. There are always periods when there are 2 or 3 negative covers in a month, but nothing close to the degree we are currently seeing. The only period in recent memory where there was such a proliferation of negative magazine covers in a short time frame was in 1998. But even that period falls short of the sheer volume we are now witnessing.

How we view magazine covers can be best summarized by our 10 Days To Successful Options Trading home-study program:

"We have found mainstream magazine covers to be an interesting contrarian sentiment indicator. When a financial trend is featured on a magazine cover, the chances are that this trend is already widely known, universally accepted, and in place for a decent length of time of very significant in magnitude."

With so much media attention being given to financial market problems, does this mean all the skeletons are out of Wall Street's closet? The magazine cover indicator would suggest that some or all the worst has passed. In fact, the latest cover story of broken "Wall Street" (along with breadth and interest rate indicators) signaled to one prominent market prognosticator that we highly respect (Paul Macrae Montgomery) that it was time to turn his Intermediate Term Stock Model positive.

This is not to say that we are completely out of the woods. One indicator that tracks the skeletons in Wall Street's closet is the spread between the 5-Year Interest Rate Swap versus the 5-Year Treasury Yield. This spread measures the risk (or willingness of institutions) to engage in a swap (two counterparty exchange of cash flows) relative to Treasury yield. When the spread is high (between 100 and 115 basis points), the credit markets are highly stressed and there is usually spillover in the equity market. This spread reached a peak of 111 following the bailing out of Bear Stearns. Since then, this spread has declined to the mid-80s. We would want to see a move back below 60 basis points, which would be a sign of a better functioning credit environment. Thus, this indicator has come well off its peak, but still has a way to go to get back in a normal range.

Turning our attention from the broad market, we see that it's not hard to find a negative cover on housing. Cover stories on housing include "How Toxic Is Your Mortgage" (9/11/2006), "Will the Housing Bust Kill The Economy" (11/13/2006), "Bonfire of the Builders" (8/13/2007), and "That Sinking Feeling" (10/15/2007). More recently, we have "Meltdown: For Housing The Worst Is To Come" (2/11/2008). As a contrarian, housing may be an area to consider a small allocation of risk capital.

On the other hand, technology has received a number of positive mentions and accolades on the magazine-cover front. Going back to the fourth quarter of 2007, "Tech is Back" (10/29/2007) led off the tech cover parade. Many of the recent covers are not sector specific within the tech group but company specific. Michael Dell was on a cover entitled "The Comeback Kid" (12/10/2007). Following that was "Google's Next Big Dream" (12/24/2007), "Company of the Year NVIDIA" (1/7/2008), "Building the Perfect Laptop" (2/25/2008), and "America's Most Admired Company. Apple is No.1!" (3/17/2008). From our contrarian perspective, we have some growing concerns in the area of tech. One may want to consider an adjustment in allocation for this overly optimistic group.

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