Trader’s Narrative

On Wednesday - February 13th - after 3 consecutive up days, I mentioned the peculiar way that option traders were in denial of the rally and of the likelihood of seeing a pause:

It would be very normal for the market to pause and digest this short term move up but the negative sentiment is undeniable.

We got the “pause and digest” the following day on Thursday and today. So to dive into all that negative sentiment, here is the stock market sentiment recap for this past week:

LowRisk.com
I mention this sentiment survey sparingly because it is very jittery and much less famous than its peers. But this week’s reading of 64% bears and 24% bulls reminds me of the last time that bearish sentiment was 60% (June 2007).

Unlike then, this week’s bullish ratio (bulls divided by the sum of bulls and bears) is quite high at 27.27%. But there is no denying that the respondents are very gloomy about the Dow’s prospects. Their median guess of the Dow (closing value February 22nd) was 11852 - well below the Dow’s January swing low of 11,970.

Investor’s Intelligence
If you’ve been keeping up to date with these sentiment overviews then you know that the II survey has been insistently and stubbornly stuck with a clear bullish consensus. For contrarians, that has been disconcerting not only because II is a major sentiment survey but because it contradicted all the other surveys.

This week it seems “reason” has finally prevailed in newsletter land. According to ChartCraft, the keeper of this indicator, the bears now account for 35.6%, and the bulls 36.7%. While that may seemingly put them neck and neck, the historical data for this survey gives us a decidedly more bullish interpretation.

Newsletter editors are naturally bullish by nature, after all, optimism sells. So it is almost impossible to find less than a third of them bullish at any point in time, no matter what the market condition. The current percentage of bulls is as low as it was in the summer of 2006 and 2002 (and no other time since). So I can comfortably say that the II is officially flashing a contrarian buy signal - finally!!.

AAII
Meanwhile, the AAII (retail investors) sentiment has finally decided to come up for air from the depths of despair it had sunk to in January 2008. The AAII sentiment survey spent 5 consecutive weeks (December 21st, 2007 to January 18th, 2008) being 50% or more bearish. The bears are now “only” 42% (with the bulls at 33%).

We’ll have to wait a few more months to see if the stock market follows the previous script or if we stray. According to the above chart, we could find the S&P 500 at 1558 by June 2008.

That’s not a prediction, by the way. I’m just extrapolating from the historic averages. But it could turn out to be prescient, so write it down somewhere or bookmark this so you can come back and mock me

Consumer Sentiment
The most recent Reuters/University of Michigan’s consumer sentiment survey was released today and it shows a stumble from 78.4 to 69.6 - the lowest since 1992!

As I’ve discussed before, consumer sentiment measures are a contrarian indicator. By the time they reflect doom and gloom, it is too late to sell, and in fact a better time to buy.

Whether that is because of the time lag built into this kind of survey or whether it is because of the forward discounting ability of the stock market (or both), the historical evidence shows that significant lows in consumer sentiment are buy signals for stocks.

I’ll going to write more about this indicator soon.

We’ve recovered around 10% from the darkest days of the market slide in January. Tragically for the bears, the world didn’t end. At least not yet.

While it all looked gloomy and depressing, it is important to remember that this is the stuff that stock market bottoms are made of: panic and fear, predominant bearish sentiment and major technical indicators hitting extremes… all accompanied by bad news.

But the market doesn’t go up (or down) in a straight line. Now we are overbought in the short term. The percentage of S&P 500 components trading above their short term 10 day moving average is slightly above 90%.

Just as an extreme low reading indicates a great buying opportunity, a high reading is an indication of caution. For more information read Lowry’s research.

Here’s a recent chart with the red line indicating the +1 standard deviation and the red line the -1 standard deviation:

Having said that, this matters in the short term. We could easily work off this level of overbought by treading sideways for a week or so. Or we could move down slightly.

A high reading from this indicator doesn’t mean it is automatically time to sell or sell short. Especially if you have a long term time horizon.

A good example of that is what happened in mid September 2007 when the percentage of S&P 500 stocks trading above their 10 day moving average peeked above 90%. The S&P 500 itself meandered for a few days and then went higher (and reached its swing top in October 2007).

The good news is that while this short term breadth indicator is overbought, the percentage of stocks above their 50 day moving average is only 40% and those above their long term 200 day moving average only 25%.

The really scary thing would be if any of these were 75% or higher. But we are still too close to the precipice ( the fall apparently avoided) for that.

Here’s the sentiment recap for this past week:

AAII
Although the participants fill out this survey after the market closes on Wednesdays, the AAII this week actually showed an increase in bearish sentiment. Considering that we had an amazingly trending upday with a wide range, you have to wonder just what it will take to sooth the ruffled feathers of retail investors.

AAII bears went from 53% to 56% while bulls came in at only 29%. This sentiment measure is now showing real fear unlike a few months ago. Back then I theorized that the retail investors weren’t scared because they simply didn’t have anything invested.

Now it seems that they are again committed to the market and very worried. Which, in contrarianland is a great sign that we are going to have a continuing rally here.

Fund Flows
According to AMG Data Services, the only week in November with positive fund flow was the second to last with a tiny uptick. The other weeks saw massive mutual fund redemptions.

In fact, the second week of November witnessed a spike of mutual fund sales which was significantly higher than mid-August this year. As scood commented, there is a huge pile of money sitting in money market funds. So it seems that the crowd has been fleeing the domestic equity market and taking refuge in fixed income.

Time to zig when the crowd zags. But what I don’t understand is if the crowd is sitting in money market funds again, why are they scared now about the stock market’s recent turbulence?

Magazine Cover Indicator
The Economist cover for this week is a bit of a conundrum. The dollar has been crashing and burning for some time now. That’s not news.

At first glance it seems to be a classic contrarian bullish cover… but the fact that they’ve used the word “panic” in the heading gives me pause. It is a bit too self-aware for my taste.

I haven’t even read the article so I’m reserving judgement but even so you could argue that the explanation matters less than the visceral effect of the image. A flaming spitfire, about to crash with George Washington calmly facing the inevitable…

What emotions do you think it conveys?

You know, I’m tired of people calling the US market a “bubble” or using words like “melt-up” or “buying panic” to describe it. These sort of pessimistic adjectives belies the bearish sentiment still pervasive in the wider market. If you want to see a real bubble in the making right now, you needn’t look far: China.

The Shanghai Composite has been on a rampage. Since bottoming in the summer of 2005 it has risen ~300%. Just recently, it hit a bump earlier this year and since bottoming in early February 2007 it has risen 50% (and counting). No matter how you look at it, China has gone parabolic.

The US large caps, which are currently leading the market, have put in a tame performance by comparison. They’ve only returned about a tenth of what the Chinese markets have. Still want to call it a bubble?

Keep in mind that I’m comparing the Shanghai Composite to the Dow and not the Shenzhen. That would make the comparison even more ridiculous since it has risen ~70% since its February 2007 bottom. By the way, this short term “speed bump” in the Chinese markets gave the world markets quite a jitter, if you recall.

Click to enlarge graph:

I’m not concerned about the US markets. But I am rather very concerned about what the Chinese bubble could mean for them. Technically speaking, the Shanghai market could fall 1000 points or about 25% and still be in a long term uptrend. How do you think the world markets would react to such a drop? what if it comes in a very short time?

The other reason I’m concerned is that the Chinese market, unlike the US markets or any of the other well established global financial markets, are riding on fumes. There is no substance behind the companies. Most of them are shells. The banks are in terrible shape. And most of the demand is internal with Chinese funnelling millions of Yuan towards a thinly veiled form of gambling.

When the Chinese bubble ends in tears (and it will… they all do) the Chinese market’s correction back to reality will effect the US markets more than anything stateside. This is something most people, both permabulls and permabears, are not yet cognizant of.

While scanning the sentiment landscape, I noticed something quite extraordinary.

The latest AAII sentiment measure is showing 54% of respondents as being bearish. By itself, that’s not unusual since we’ve seen numbers like it before. What makes this bearish sentiment historic is that:

1. it is very bearish (significantly so)
2. it follows a rise, not a fall in the stock market

Never in the 20 year history of the AAII have we seen such a rise in bearishness coupled with a rising market.

Let me say that again, this has never happened. Whenever we’ve seen such extreme bearishness it has been after a significant market decline and has actually been a reliable signal of the formation of a bottom.

Yet, here we are. The latest survey shows almost 2 times more bears than bulls - after the market has rocketed higher almost everyday.

What does it mean?
Unless this is some calculation or reporting error on the part of the AAII it means that the retail, Mom’n'Pop investor is spooked by the recent rise in the market. They don’t trust it. They think it is fake. They think the market will actually fall. During the March 2007 market decline they were nervous but not this nervous! At the bottom of the March decline, they were 45% bearish. Now, even after a breathtaking market recovery, even after new highs, they are 9% points more nervous.

What implications does it have?
From a contrarian point of view, this may seem automatically to have bullish implications. But if people start to act on this bearish feeling by taking money out of the market… selling mutual funds, selling stocks, etc. then it may in fact be bearish. As long as they remain as “smart” unbelievers, on the sideline, this would be bullish.

The level of caution everywhere is rising faster than the stock market. I’ve noticed it on blogs (cough), newsletters, columnists, etc. As the Wall Street saying goes, bull markets climb a wall of worry. Right now, you can have your pick: inverted yield curve, dollar, GDP, stagflation, unemployment numbers, etc… The bears are great at creating laundry lists of such reasons.

Maximum Pain
But if something is obvious to everyone, then it doesn’t matter. The market behaves in such a way so as to inflict maximum damage to the maximum number of portfolios. Its job is to kick you off. Your job is to stay in and ride the trend.

This latest AAII sentiment number is certainly a curve ball. Should we take it at face value? or try to out smart it?

Whatever happens, it is exciting to live a never before seen moment in market history.

As Spock would say, Fascinating.

On a different note, I’ve continued to add articles, books and other choice trading related resources to my box.net widget. Make sure to check it out and let me know if you have any special requests.