IRA Investing: Building a Base

A good bounce last week took a bit of pressure off investors in the short run, although most of what I saw related to relief rallies in very depressed financials and commodity-oriented companies. Hidden in the rally were various disasters that occurred when specific companies reported disappointing earnings. I would have thought that the decline up to this point had already discounted some earnings shortfalls in economically sensitive companies, but I guess not.

I continue to hope that we have entered a period of base-building by the market that will ultimately be resolved on the upside. Economically, I believe we are going to see a whole string of new programs designed to deal with the current recession, starting with a bailout of homeowners who are facing foreclosure.

I have heard some interesting proposals, including dropping capital gains taxes to zero on any house purchased in the next two years or offering accelerated depreciation on homes that would be purchased by investors for rental. However, these proposals are too simple and would most likely be seen as a favor to rich investors -- something we can't put up with in the current environment. Therefore, I expect a monstrous government program that will buy up mortgages or something similar that will allow homeowners to renegotiate their mortgages. Ultimately, I expect serious inflation because it is going to be very difficult for the government to back out of these programs at exactly the correct time. I believe the Federal Reserve will choose inflation over deflation every time.

The stock market bounce has caused my indicators to weaken somewhat, but they are largely still bullish. The most disappointing of my indicators measures odd-lot investor activity; these investors are still buying and avoiding the short side of the market. That behavior is surprising given the magnitude of the decline. It's almost as if the market declined so quickly that these investors were stunned. Now they are reluctant to sell, thinking they are too late. I think that attitude will change.

The difference in confidence levels between smart investors and dumb investors is still very high and extremely bullish. However, the levels of this indicator are still below those reached at previous major bear-market bottoms.

Similarly, the flow of money into the Rydex family of funds remains at a bullish level but well below levels reached in late 2002 and early 2003. Interestingly, this flow of money went back to the bullish funds at the end of last week -- a bearish development for the short term.

Detrended CBOE Put/Call Ratio vs. S&P 500

Click here for larger image.

Finally, let's look at the equity-only put/call ratio.

This chart shows a 10-week moving average of the put/call ratio in red. The S&P 500 is shown in black, and the green trend lines relate to the average of the indicator and its standard deviation. This indicator has been adjusted to remove long-term trend influences.

Two weeks ago this indicator nudged into very bullish territory but it was still well below levels reached at the 2002 stock market bottom. Last week the ratio declined, bringing the indicator back down from extreme levels to a simply bullish level. It has been disappointing that these put and call buyers are eager to move to a more bullish posture in this kind of market.

---

At the time of publication, Moore was long Conmed, Lincoln Educational, Super Micro Computer, Smithtown Bancorp, Sybase and USA Truck, although positions may change at any time.

Richard Moore, CFA, has 40 years of experience in various facets of the investment business. He has been employed by banks, mutual funds and investment advisory organizations during his career and has also owned retail and service businesses. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Moore appreciates your feedback; click here to send him an email.