Trader’s Narrative

I took a few days off (hope you didn’t miss me too much). Let’s catch up by looking at the important sentiment developments:

ISE Sentiment
I mentioned the ISEE during last week’s sentiment overview when it increased slightly as the market fell, showing that retail option traders were seemingly not worried. Even more bizarre, during the past shortened trading week as the market staged a strong recovery, the ISEE value actually fell.

Part of the explanation for this aberrant behavior may be that I’m looking at the “All Securities” data for the ISEE, rather than the “Equities Only”. The latter measure showed no similar increase for the week of May 23rd.

CBOE Put Call Ratio
Again, in contrast to the ISEE’s behavior, the CBOE equities only put call ratio showed this past week that traders became more bullish as the market rose. Although not the ideal, this is the normal pattern.

The put call ratio fell to 0.59 - approaching levels of bullishness which have previously caused stock market rallies much difficulty.

Hulbert Newsletter Sentiment
According to Mark Hulbert, the Hulbert Stock Newsletter Sentiment Index (HSNSI) has almost doubled from +16.2% to +31.2%. And it did so from mid May to the end of May 2008. Although this is an significant increase, I don’t think it presents us with a situation commensurate with market top.

To give you an idea, during mid to late April 2006 the HSNSI reached +73.2% - when the S&P 500 index soon after fell from 1325 to 1225. And during the bear market bottom in October 2002, it fell below -60%. So all I can say from the current reading is that more newsletter editors are jumping into the bullish camp but still not enough to cause serious problems.

AAII
According to the American Association of Individual Investors’ sentiment survey, there are now 31% bulls, down 15% points from last week’s 46% bulls.

This is a welcome reprieve, especially as it is accompanied by a lower market. Had this key sentiment survey remained unchanged or actually increased in bullishness, the sentiment tone would be definitely different.

Investor’s Intelligence
Similar to the AAII survey, the II sentiment measure fell from 47% bullish to 37.9%. I was worried about this since last week’s number was almost 50%. The keepers of this measure, the editors of ChartCraft, Burke and Gray agree with my general take on the market’s sentiment:

“While the sentiment is moving away from a bullish reading it is not yet close to calling for a market top”

I continue to see a lot of long term positives for the market and continue to believe the March bottom to be a major one. What I suspect we are seeing is a (hopefully) shallow pull back or pause before the next leg up.

Magazine Cover Indicator
Uh oh. Anyone long crude oil or any traditional energy related equities should be worried.

The Economist isn’t the most widely read publication but their cover stories still do carry weight - in a contrary sense most of the time. The price of crude has already tapered off and I suspect this will be either a significant top or at minimum a longish pause.

There are, of course, other signs that the whole energy rally has run its course. There are several technical signs, including the increasingly sharp slope of the trendlines as well as ominous candlestick formations.

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).