Trader’s Narrative

AAII
The retail investors as measured by the American Association of Individual Investor’s weekly sentiment survey are astonishingly pessimistic: 54% bearish.

To find a more gloomy view from the retail investor’s camp we’d have to go back to mid January when the AAII sentiment reached 59% bearish.

Back then I showed you this chart:

We have definitely seen 13 weeks pass since then and within a few more weeks will also complete 26 weeks. But unlike the historic average shown in the bar chart above, the market has yet to hold a decisive rally.

The S&P 500 Index (SPX) did momentarily reach a high of 1440 but couldn’t hold on to it. For most of the time we’ve been trading below the levels at which we first saw a +50% bearish AAII sentiment. As I’ve outlined before, sentiment during a bear market is a different beast.

Hulbert Newsletter Sentiment
Mark Hulbert is worried that while we may have put in a significant bottom with the March low, it may not hold. According to the Hulbert Stock Newsletter Sentiment Index (HSNSI) the average exposure recommended is a paltry 2.2%. And while this is low, back in early March the average newsletter editor was downright panicking with a -29.2% exposure - meaning actually being short the market with almost a third of total portfolio allocation.

As we head into a possible retest, it isn’t reassuring to see sentiment sitting so much above those levels. The ideal sentiment that would catapult us higher would be an even more intense panic with the kind of market weakness we’ve seen. While that may change anytime, the HSNSI doesn’t reflect that right now.

Investor’s Intelligence
No significant change in this sentiment measure: bullss dropped from 44.8% to 43% and bears increased slightly from 31.1% to 32.6%. It isn’t offering much of an edge as it sits in lukewarm waters similar to the Hulbert analysis.

CBOE Put Call Ratio
While the traditional put call ratio (equity only) did rise during the turmoil of this week, we didn’t see it reach or exceed the important 1.0 milestone. In fact, it only was able to muster a high of 0.84 on Wednesday. That reflects a good amount of fear but just not enough to carve out an important inflection point.

ISEE Sentiment
This past Wednesday and Thursday the ISEE Sentiment measure fell to 74 and 75 - the lowest since mid March low this measure reached 56 (March 10th 2008).

Remember, the ISEE sentiment numbers are calculated differently from the CBOE put call ratio. For one, the ratio is inverted with calls as the numerator and puts as the denominator. Further, the ISE only uses options which are traded by non-market makers, stripping out the noise and showing what retail and institutional traders are doing. And lastly, the ISE data is for opening orders only.

All in all, a much more robust and useful measure of options trading sentiment.

Rydex Traders
According to Jason Goepfert:

Rydex traders had finally started focusing on “safe” funds more than “risky” funds - a stark change from earlier in May when they were five times more likely to trade a risky fund than a safe one. As of yesterday, the ratio fell under 0.5, meaning that those folks were more than twice as likely to trade a safe fund than a risky one.

Conclusion
Since I eschew using a single indicator to light the way, the weight of the indicators are confusing with many cross currents pulling me in different directions. The troubling and somewhat muddy sentiment outlook doesn’t help. Hopefully things will resolve themselves soon and the picture will become clearer.

The sentiment landscape has changed much from just a month ago:

Sentiment Surveys
The AAII sentiment survey came in this week at 53% bulls - unchanged from last week. Not only is this a very high bullish reading for this indicator, it is the level at which the market topped out last October. Furthermore, the fact that it has remained firm in the light of this past week’s market performance should be sending chills down the spines of bulls.

From a contrarian point of view, I want to see the retail investors (AAII respondents) become fearful as the market is falling and remain so even as it rises. The fact that they have now quickly shuffled over from extreme bearishness to bullishness and maintained it for two weeks, even as the market fell, reinforces my belief that we are in for some trouble.

In contrast, the Investor’s Intelligence survey is showing 44.4% bulls and 32.3% bears. There was a slight increase in the bullish numbers and an even larger increase in the bearish camp. Still, according to the current II we aren’t anywhere near bullish extremes. Take for example that the bull/bear ratio is 1.37 - it was more than 3.0 when the market topped last October.

Rydex Nova/Ursa Ratio

In case you’re not familiar with this indicator: before the onslaught of ETFs, Rydex’s Ursa and Nova were the ticket if you wanted to time the market. The are mutual funds but they settled twice daily (I don’t think they do anymore) and you could switch assets between them or other Rydex funds with no penalty. Like other contrarian indicators, when the fast money crowds to one side, the smart thing to do is to jump to the other side.

Right now the ratio is showing an abundance of optimism from the Rydex fund timers. Something which makes me wary. On its own this wouldn’t be enough to really concern me but it is just one more in an ever growing list of short term indicators which suggest some sort of correction or pause at best.

Fund Flows
The only bright spot, from a contrarian perspective, in the sentiment overview is the mutual fund money flows. According to AMG Data, one of the largest and most accurate providers of this sort of data: domestic (US) mutual funds reported net redemptions (outflows) of $8.6 Billion. This dovetails with the panicky behavior we’re seeing in Canada.

With interest rates so low, and cash being basically a negative return investment, you won’t be surprised to learn that money market funds had the largest monthly outflow in April ever on record: $78.7 Billion. Some of the cash flowed into municipal bond funds ($4 B), no doubt in search of a higher yield. But I suspect much of it, perhaps even the vast majority, was the US consumer’s retrenchment.

Finally, among the sectors, real estate funds received the largest inflow of money since February 2007 - which was exactly the worst time to buy REITs or anything else real estate related in the stock market.

So while this beleaguered sector has valiantly fought back from the January 2008 lows, it may be about to top out (again). Look alive out there.

The market is bumping its head against a resistance range from 1400 to 1450. This area was of course, support just a few months back.

Starting from April 18th, I noticed a change in the market tone. Whereas pretty much every single indicator had been flashing buy in January, February and March, one by one, they started to point to caution:

• too many stocks above their 10 day moving average
• a fourth attempt at the 1400 level
• AAII sentiment back to October 2007 bullishness and the ISE call put ratio too high
• trading volume low enough to cause concern
• 78% of S&P 500 stocks above their 50 day moving average
• “Sell in May and go away!”
• market stretched above its 50 day moving average
• AAII sentiment inches even more to bullish excitement
• number of S&P 500 52 week highs compared to 52 week lows signals caution

The best scenario for the bulls would be for the market to pause here and digest this overbought condition and then continue to move higher, breaking above the flag or pennant formation.

Here is the lay of the sentiment land for the week:

Barron’s Institutional Survey
According to the latest Barron’s “Big Money Poll”, the professional investors are fairly bullish but not excited about stocks (see graph). But the majority, 55%, believe the market to be undervalued.

And 87% say they see themselves as buyers within 3-6 months. The remaining 13% see themselves as seller in that time frame.

AAII Sentiment Survey
The American Association of Individual Investors sentiment survey continues to be problematic for bulls. From a contrarian point of view, the ideal is if sentiment remains unchanged or even falls in the face of a market rally. What we are seeing however is the opposite. As the market has recovered, the AAII sentiment survey has shown an alarming increase in bulls.

I mentioned this last week in the sentiment overview and unfortunately, things have gotten slightly worse. Now only 26% of AAII respondents are bearish and 53% are bullish. There is no way we can discount or ignore this. Such a high level of bullishness is downright frightening - from a contrarian point of view. The last time we had this many bulls in the AAII was in October 2007 when the market put in its swing high.

I’ve been also noticing technical indicators also pop up showing a potential for the recovery to stall. So while in the short term we might be in for some turbulence or even a set back, I still think there are enough things in place for a protracted bull market.

Fund Flows

According to AMG Data, for the first 3 months of 2008 equity funds had a net outflow of $29.7 B - including ETFs. Domestic funds had an outflow of $22.5 B.

By March the panic was apparently over and mutual funds and ETFs once again had net inflows: $14.7 B for the month. Net outflows during corrections tells me that the retail investor isn’t stubbornly clinging to hope. But selling in fear that things will get worse. But in the end, the market needs inflows to be able to power ahead.

When you combine the healthy return of inflows to mutual funds and ETFs with the limited supply of securities due to a lack of IPOs, and secondaries as well as the further restriction of supply through continuous buy-back programs, you have the right setting for a powerful bull market.

Warren Buffett: “worst is over”
The Sage of Omaha believes that “the worst of the crisis in Wall Street is over”. In an interview he said that he supported the Bear Stearns buyout because there was a real risk of contagion had it fallen. He also thinks “the Fed did the right thing” by stepping in and acting as a direct lender to the financial companies in need. Of course, this is little consolation to those who are being squeezed by the mortgage crisis but from a trading or investment point of view, it is nice to have someone like Buffett confirm that Armageddon was averted. At the same time, Buffet - unlike Richard Russell - is not a raging bull. He thinks that we will see moderate future growth, much less than in the past decades.

PVA Valuation
This isn’t really sentiment, as such, but I include it because it dovetailed nicely with Barron’s poll results where most respondents believe the stock market to be undervalued.

Ford Equity Research uses a proprietary measure to determine valuation for a company. They take the market price of the company’s stock and divide by value, derived from “a proprietary intrinsic value model”. According to Ford, 40% of the almost 1,800 US stocks it tracks are undervalued.

This, by itself, wouldn’t mean much except that this measure has an enviable track record. The previous times that it showed a higher percentage of stocks undervalued was at the end of 2002, as the bear market ended, with 48% of the stock universe undervalued. The second instance when there were more than 40% of stocks undervalued was in 1998, during the Asian financial crisis (also known as the LTCM debacle).

Everything seemed to be going alright and then GE came along and whacked the markets with their largest earnings miss in at least three years.

Any way you cut it, Friday was a horrible day (for the bulls). There were 2440 issues declining on the NYSE (out of 3211) and on the Nasdaq, 2,290 fell out of 3,037 traded. Advancing volume was dwarfed by declining volume - 9:1 on the NYSE and 6:1 on the Nasdaq.

Of course, I don’t think that GE is the real cause of the market’s fall but it is a comfortable excuse for most. I outlined my hesitation that the market was approaching resistance levels and that the odd lot short sales were too high to give me reason to believe that the rally would continue.

Surveys
According to Investor’s Intelligence, newsletter editors are for the most part unchanged in their view of the market. Meanwhile, the AAII sentiment has now recovered that it is slowly approaching just a tad too much optimism: 46% bullish, 37% bearish.

The same can more or less be said for the other sentiment measures: LowRisk, Consensus, and MarketVane, so I won’t bore you with their mundane details.

Put Call Ratios
The decline wasn’t enough to push the CBOE put call ratio to parity. It climbed to just barely below 0.90 - below levels which we would associate with panic:

Before Friday’s thrashing, the small option traders as measured by the proprietary ROBO ratio had actually increased their pessimism despite the market’s recent rise. I always take notice whenever sentiment goes in the opposite direction of the market it is tracking. But again, this was before GE threw a monkey wrench into the works.

NFIB Sentiment
The National Federation of Independent Business (NFIB) is reporting that small business sentiment in the US is at an historic low. They have collected information from their small business members for more than twenty years and this most recent response is the gloomiest assessment of business outlook ever.

So it seems that the horrendous consumer sentiment has company.

As you would no doubt surmise, such pessimism is actually good for the market. Whenever we have an excessive level of doom and gloom, the worst is already behind us. I’m referring to the stock market here because while there may be real pressure on consumers and small businesses, the stock market is a forward discounting mechanism.

And because it looks forward while other indicators measure the past or present, it can seem to be paradoxically the opposite of the real economy.