Trader’s Narrative

Here are this week’s sentiment cross currents:

Investors Intelligence
The measure of stock market newsletter editors sentiment published by ChartCraft shows 36.0% as bullish and as 37.2% bearish. This is a reversal of the previous two weeks where we had seen the bulls outnumber the bears. It is difficult to dismiss the rapid increase in bullishness we’ve seen since the March lows as a hallmark of bear market rallies since we’ve seen the same II pattern in previous new bull markets.

American Association of Individual Investors
The sentiment survey of retail investors shows a reduction in number that were unsure from 29% to 20%. The 9% increase in conviction was almost equally apportioned, with 36% bullish and 44% bearish.

Perhaps more meaningful is the asset allocation of the AAII. They have a paltry 41% of their portfolios dedicated to equities. This is the lowest in the history of the survey (going back to 1988). It is slightly lower than what we saw on previous long term market bottoms: early 1991 and late 2002. As well, to highlight the insecurity the average American retail investor is feeling, they have pushed their cash allocation all the way to 45%. Not only is this an all time high it is the first time that the size of cash in portfolios has trumped equities.

Hulbert Newsletter Sentiment
Since the March lows, the HSNSI has jumped by more than 45% points. While some increase in optimism is warranted in a new bull market, this much of an increase is atypical of the historical playbook. During the first 52 days of the average bull market since 1965, the stock newsletter editors that time the market have on average only increased their bullishness 29.3% points. You can read more about Mark Hulbert’s recent research into the pattern of sentiment in new bull markets. This was featured a few days ago at news.tradersnarrative.com where you can find a continuous stream of interesting articles.

Option Sentiment
Nothing really new in this area, see previous week’s sentiment overview for further details. That discussion is still valid.

Sell In May And Go Away
You know the old Wall St. adage, “Sell in May and go away”. Well, here we are. We have now officially entered the time period which has historically been most difficult for the stock market.

So far we’ve had a tremendous rally off the March lows: the S&P 500 index gained 28.4% and for the two months of March and April, it has risen 25% with most of it coming from March. April’s gain was 8.2%

Looking at market cycles, this is rare. To see such a similar strong performance for the months of March and April we would have to go back to the 1930’s where intense bear market rallies were the norm. In those times, it wasn’t a good time to put fresh money to work (hence the label of bear market rallies and the annual cyclical nature of returns).

Big Money Poll
Last weekend brought out Barron’s quarterly Big Money poll. The small group of strategists surveyed were decidedly optimistic with 59% stating they were either bullish or very bullish. While a surprising 58% stated that they didn’t believe the market had bottomed yet, almost the same percentage (59%) identified the stock market as the best asset class for the next 6 to 12 months going forward. I’ll leave you to ponder the riddle of their logic.

The problem with the Big Money poll is that in its history, as a group, it has never been truly bearish. So while we would like to use it as a contrarian measure, we really can’t because for the most part it has no edge.

Drilling down into the sectors, the most unloved were Transportation and Utilities. In contrast, the Big Money poll liked corporate bonds, emerging markets (Latin America & Asia) and oil. But the one thing they almost all agreed on (84%) was to be bearish on US treasuries. This is puzzling since they’ve been persistently bearish on bonds for the past 8 years in the face of a powerful bull market in that asset class - especially in 2008.

Wall St. Strategists
The insistent bearish stance of the Big Money poll participants is in contrast to the current recommended allocation by the average Wall St. strategist. Right now they’ve peaked at a suggestion of 38.9% of client portfolios to (US long term) bonds, which is the highest in 12+ years. The last time they were even close to this level was in 1998 (34% allocation) when bonds topped and didn’t regain their previous high for another 3 years.

The asset class garnering the highest allocation is equities with a 52% weighing. Similar to the Big Money poll, Wall St. strategists are never outright bearish. Their bullishness is either raging or reluctant. So put in that proper context, the current allocation is very timid. It is the lowest allocation to equities since 1997. And during the bear market bottom of 2002-2003, their equity allocation was 68%.

Free Access to EWI
There has been such a crushing demand for the FREE 120 page report from Elliott Wave International that they’ve extended the offer for a few extra days. It is a mini-book covering the US, European and Asian markets as well as interest rates, commodities, currencies and much more. This is the most recent edition of their comprehensive Global Market Perspective and is exactly what their regular paying clients receive (except they pay $199 and you’re getting it free). But it is only available free for just a few more days. There’s no obligation to purchase anything and you only need your email. I’ll go over it shortly on the blog so download your copy now.

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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).