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.

A bull market climbs a wall of worry. Or so goes the Wall Street maxim. The market has a love/hate relationship with bears (and they with the market) but it needs bears fervently. A bull market feeds on bears and their panic, fear, caution and disbelief.

A great way to quantify the bears and their activity (as opposed to just their sentiment) is to track short interest positions. This data is released by the NYSE and Nasdaq exchanges on regular intervals. And although like the commitment of traders, it is somewhat dated data, it is still very useful.

But it can get tricky because we can’t really start comparing today’s data to say 5 years ago. If you look at a chart of short interest you notice that it just keeps going up and up (the opposite of cumulative breadth). That’s because the market, trading volumes, number of listed securities, etc. have all increased. So somehow we have to convert a series into an oscillator to extract meaningful data. There are a few methods but the most simplest is to track the data series relative to a moving average of itself. Another is to compare it to the daily average volume in the market. This is called short interest ratio.

Right now both Nasdaq and NYSE short interest ratios are at levels which show a remarkable disbelief in the bull market. Last month saw a 9% increase in Nasdaq short interest and the last 5 months a 33% rise. The NYSE short interest ratio is a bit more extreme than Nasdaq’s in fact. So as the market has continued to rise, more and more people are betting that it will fall.

All these short positions puts a floor beneath the market. If the market begins to fall, shorts will cover to profit (buy). A large short position can also be the fuel for momentum. If the market continues to rise, shorts will cover (buy) as their stop losses are hit.

Another measure is to look at odd lot purchases and odd lot short sales. These are transactions made with less than 100 shares, therefore they must have been made by small traders or investor. NYSE odd lot purchases and NYSE odd lot short sales are both in neutral territory relative to their historical extremes. The public doesn’t have very much conviction one way or the other right now.

As long as these two measures do not reach their extremes (for short sales, low levels and for odd lot purchases, high levels) we’re in the clear and the market can continue to climb. But sustained readings at those extreme levels would be bearish because the public would then have come to fully believe in the rally and throw caution to the wind.

But picture isn’t quite so uniform in its bullishness. NYSE public short ratio which measures only public traders/investors as opposed to specialists and member firms activities is a tad high. This is confusing because it doesn’t confirm the odd lot shorts measure. Who said this was easy? Perhaps this is because while the short interest data moves slower in an easily definable trend, the public short ratio and the odd lot measures are much more erratic and volatile. So we may very well see them quickly come into alignment with the short interest data.

Tells you a lot about the sort of market we’re having when after only a -1.36% move, the bears can be said to have flexed their muscles and roared a bit.

But for a strong down day, its surprising how muted the damage was.

Put call ratios didn’t budge. The CBOE put-call ratio was only 0.62 - I’d like to see 0.5 or lower for real panic. The ISEE options snapshot was 117; meaning 117 calls were bought as opening positions for every 100 puts. Yawn.

Sentiment wise, while I was a bit concerned about the Investor’s Intelligence numbers before, now it has become undoubtably negative. Just today the II’s bears shrank to less than 19%. You’d have to go back to the summer of 2004 to find a lower number.

By the way, LowRisk, which reached an extreme historical low just last week, is now at 48%. Smack dab neutral. I told you this thing was as skittish as a chihuahua after 6 espressos!

Also, the volatility measures VIX and VXN hardly budged. Sure, they ticked up but nothing that would hint that this decline had induced any serious worry.

This is the sort of market condition that drives everyone crazy. Or atleast me. I can’t see any sort of edge on a tape like this. So I’m left mostly on the sidelines.

Finally, everybody and their uncle must be staring at this chart right now, wondering if it will indeed turn out to be a double top:

LowRisk is probably one of the least known and followed investor sentiment surveys.

It is a bit of a mystery how large the sample size is because Jeff Walker, the person who runs it, won’t disclose how many respondents he gets or has gotten historically. In any case, all we can do is take the data and see if it provides an edge or not.

Every week, anyone with a computer and internet access can fill out a simple question:

How do you think the DJIA will perform in the next 30 days?

• Up 2% or more
• Flat (less than 2% up or down)
• Down 2% or more

There’s also another metric where they ask you to “guess the Dow”. LowRisk has been collected non-stop since 1997 and has proven to be a good contrarian measure.

Which is why it is notable that for this week it flipped from a neutral reading to a very bullish one. Right before the recent market swoon (June 3rd 2007), LowRisk showed 40% bulls and 34% bears.

But on June 10th 2007, there were 14% bulls and 60% bears.

That is very extreme. Even for LowRisk which is one of the most volatile sentiment surveys. In fact, there were only a handful of times in the past with such few bulls:

March 27 2005 —- 14.50%
July 25 2004 —- 14.30%
August 21 2005 —- 12.10%
April 18 1999 —- 12.00%
October 17 2004 —– 10.50%
September 19 1999 —- 10.30%
September 9 2001 —- 10.30%

During those past instances it did a spotty job of pinpointing great buying opportunities. Almost all of those dates correspond to a small bounce, but they were usually followed by a much better buying opportunity (lower bottom) in the immediate future.

There is another way we can slice and dice the data. Lets look at the bull ratio: bulls divided by the bulls plus the bears. This way we compare the two extremes and take out the neutral bystanders.

By that measure, the latest bull ratio of 18.9% is also one of the lowest historical instances. Here are the other times that the bull ratio was lower than 20%:

September 2 2001 —- 12.20%
September 19 1999 —- 13.84%
October 17 2004 —- 15.35%
August 21 2005 —- 16.64%
April 18 1999 —- 17.65%
March 9 2003 —- 18.06%
March 18 2001 —- 18.20%
September 25 2005 —- 19.37%
March 27 2005 —- 19.46%

As you’ve no doubt noticed, there’s a lot of overlap between the two lists. So what I said above applies to this list as well. The only standout date, because it turned out to be an amazing time to buy, was March 9th 2003. This was the third and final retest of the bear market bottom, just before the lift off to a new bull market.

Now the caveat. This is the most bearish (therefore bullish by contrarian analysis) sentiment measure. But it is just one data point.

Also, as I’ve mentioned before, LowRisk is very skittish and jumpy. Which is why it is usually smoothed with a short term moving average. Right now, its moving average is still in neutral… although with a few more numbers close to this extreme low and we’re going to see even the moving average reach extremes.

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.