Trader’s Narrative

Money tends to get shuffled around from place to place and hand to hand.

Within the financial markets the big three boxes are stocks, bonds and cash. When the bets are placed, over time, the retail traders tend to lose and the deep pocketed, well informed institutional traders tend to win.

So by looking at where the retail traders are placing their bets, we can get an idea of where to not place ours.

AAII Allocation Data
The American Association of Individual Investors (AAII) is famous among those who track sentiment for their weekly survey. But they also keep track of several other key data points. Among them is the allocation ratio of their members between cash, bonds and stocks.

From the latest data, AAII respondents have said that they have increased their cash positions to almost a third of their portfolio value. This is the highest cash levels since late 2005 and 2002. To raise the cash allocation, retail investors have sold their equity holdings.

In comparison to the summer of 2007 when the allocation for equities was almost 70%, today it is just above 50%. To find similar levels we’d have to go back to November 2005, summer of 2002 and May of 2003. Each of those instances were great buy points with a long-term time horizon.

But remember, this is as reported by the membership of the AAII. There is no way for them to verify if indeed what their members are reporting about their allocations is true. So let’s take a look at actual fund flow data.

Fund Flows Data
According to AMD Data, July’s money market funds reports net cash inflows totaling $44.402 billion! That is a very large amount for one month.

Back in April, I pointed out the reverse: a massive exodus from money market funds to the tune of almost $80 billion. Since then the average mutual fund investor has consistently increased their cash position - which would tend to lend credence to the AAII survey results.

Caveat Trader!
The market always throws curve-balls to keep things unpredictable and exciting. So remember, retail traders are not always wrong.

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.

Here’s this past week’s sentiment data:

Sentiment Surveys
Investor’s Intelligence (measuring the newsletter editors market bias) is showing a surprising amount of bullishness at 56.5%. This is a slight increase from last week. The II bears fell slightly to 22.4%.

In contrast to newsletter editors, the AAII survey (measuring retail investors) is showing only 36% bulls and 47% bears. Since last week the bears increased by approximately the same amount the AAII bulls decreased.

Although odd, this isn’t the first time these two sentiment surveys have been at loggerheads with each other.

Fund Flows
According to AMG Data, US mutual fund investors withdrew $15+ Billion from equity mutual funds (not including ETFs). Most of that was from domestic funds and the remaining from foreign funds.

This is HUGE!! I can’t really understand what is going on or even if this statistic is correct. If it is, it is larger than any weekly withdrawal for more than 6 years. It is even larger than what we saw in the darkest days of the 2002 bear market. Wow!

Some portion of this gargantuan number is due to the year end effect when mutual fund investors have their last opportunity to square things tax-wise. But as I already pointed out, this is nothing like we’ve seen in previous year end tax selling. Something big is going on. Obviously when people are selling their equity investments at such a torrent, it is wiser to exit the crowd or even fade it.

State Street Investor Confidence:

State Street is one of the largest financial firms in the world. They have a unique sentiment measure which relies on aggregate data from their position as custodians for investment managers:

Unlike other survey-based confidence measures that focus on expectations for future prices and returns, the Index provides a quantitative measure of the actual and changing levels of risk contained in investment portfolios representing about 15% of the world’s tradable assets.

The interesting thing is that this month, the State Street Investor Confidence Index plumbed depths which it had never seen in its entire history!

If you want to get more info on this sentiment indicator as well as full historical data (monthly), check out the FREE Trading Resource section (under Reports & Articles). While you’re there, be careful or you might find other interesting stuff to busy you for hours