Trader’s Narrative

Here is the wrap up of this week’s sentiment data:

Sentiment Surveys
The weekly American Association of Individual Investors (AAII) stock sentiment survey shows a surprising increase in optimism. Of the respondents, 44% were bullish (a 5% increase from last week) and 35% were bearish (a 10% point drop from before). We aren’t near any sort of extreme level, however the direction of sentiment is puzzling since the stock market closed lower than it has for the past 18 days.

Investors Intelligence
The stock newsletter editors, as measured by ChartCraft’s Investors Intelligence, shows a similar increase in optimism. This week the II had 50.6% bulls (4% point increase from last week) and 23.6% bears (a 0.8% decrease). I’m not sure how helpful this is as the Investors Intelligence bull/bear ratio has been relentlessly hovering around 2:1 for the past few months.

In contrast to both of the above sentiment surveys, the Hulbert Stock Newsletter Sentiment index which measures a sub-set of market timing newsletters is showing a decline in bullishness. The HSNSI was at 45.2% when we hit an intra-day high of 1080 on the S&P 500 index. But now it stands at less than 29.1% a significant sentiment erosion in response to a small retreat in the index.

A recent survey of institutional investors by TheMarkets shows that an increasing number of them believe we have seen a definitive low. While in June 40% thought so, now 70% do. Furthermore, 90% of them expect the S&P 500 to climb to the 1200 level by the end of the year in 2011. Back in March only 50% were as optimistic about the S&P 500 reaching that goal.

Fund Flows
An estimated $29 billion was withdrawn from equity mutual funds (domestic) by US retail investors for the month of September. Meanwhile, they dove head first into fixed income funds by buying almost $46 billion worth of taxable and municipal bonds last month. This is a continuation of the trend which I highlighted before: Equity Mutual Funds Show Outflow Even After 60% Stock Market Rallly.

So if it isn’t Mom’n'Pop investors and it isn’t corporate insiders, who is buying? Leaving aside conspiracy theories of the Plunge Protection Team - because let’s face it, if they exist they are very bad at their job - we are left with opportunistic hedge funds. The usual suspects are either grey/black boxes or discretionary traders chasing a momentum market higher. Remove this remaining leg and the table get mighty wobbly.

Option Traders
The short term moving average for the ISEE sentiment index (equity only) fell slightly from last week’s high of 196. As you can see from the chart, these were gidy levels which we hadn’t seen since late 2007, just before the bear market began:

Zooming in on the week’s data, the ISE sentiment index hit a high of 204 on Tuesday but as the S&P 500 fell for the rest of the week, it actually registered a slightly more optimistic tone. I was watching to see if we would make it down to 100. But this small decline was not enough to rattle anyone in the ISE.

The CBOE put call ratio (equity only) reacted slighly more in response to the weakness in equities:

In contrast to the stubborn complacency shown in the ISE option data, the CBOE (equity only) put call ratio jumped to 0.84 on Friday - getting really close to the noteworthy 1 level. As well, the ratio increased every single day of the week, even on Monday when the S&P 500 closed higher.

Grey Beards
Checking in this week with a market guru who both literally and figuratively has earned the title of a ‘Grey Beard’. Steve Leuthold, the 71 year old money manager who is not afraid of going short, is very bullish right now.

Leuthold expects the S&P 500 to end the year at 1200 and even higher at 1350 next year. In keeping with that bullish view, he has 72 percent of his fund invested in equities.

“There’s pretty good momentum, and the market psychology is right. The markets turned up before the economy did. Now, the economy is improving. It might be a little better than most think. It ain’t wonderful, but it’s a lot better than it was.”

Meanwhile, Doug Kass and David Rosenberg as well as Bob Janjuah of RBS - all of whom I’ve mentioned before - remain decidedly bearish and unmoved.

The fabled trillion dollar cash hoard that US mutual fund investors are sitting on is well known by now. But what isn’t equally well known is just what they are doing with all that cash. We do know that after reaching a peak right at the March lows, the shell shocked US retail investor stopped stuffing cash into their accounts.

At its peak the cash hoard was about $4 trillion dollars. By the start of this month, it was down to $3.56 trillion and the most current data shows that retail investors have continued to slowly exit their safe haven, taking the number further down to $3.48 trillion. So where have all those billions of dollars gone?

From the fund flows data it seems that the vast majority of it has been funneled to the fixed income market, and more specifically, taxable bond funds. I showed a pie chart of the fund flows in last week’s sentiment overview to juxtapose the extremely skewed ratio of money flowing into bond funds vs. equity funds.

But a pie chart doesn’t really do the data justice. To get a much clearer idea of what is going on in the hearts and minds of the average US retail investor, let’s take a look at how they’ve allocated their money between domestic equity funds and bond funds:

The data for the bond funds is for both taxable and municipal bond funds. As well, this month’s data point (shown in a darker shade) is partial because it including only the first 3 weeks. Nevertheless, this chart is a telling a remarkable story.

First, not surprisingly, as the bear market took hold, people started to react by taking their money off the table. The worst month was October 2008 (not March 2009) when $72 billion was withdrawn from equity funds - $47 billion of that from domestic funds. At this point of maximum panic, US investors sold everything, even bond funds. They only trusted one thing: cash.

But by the start of the year, while they still distrusted the stock market, they began to change their mind about bonds. Each month they put more and more money into bonds, even as the stock market launched on an astonishing rally.

Month after month, as the S&P 500 went on to higher highs, US investors continued to ignore equity mutual funds. Then most shockingly, during the first 3 weeks of this month, they actually withdrew funds from this asset class! At this rate, by the end of the month, we’ll see outflows equivalent to December 2008. All the more astonishing as the S&P 500 is hundreds of points higher.

This is simply astonishing. What exactly does a stock market have to do to get some respect around here?

Bullish
There are two ways we could look at this. If you’re bullish, you would say that the fact that the retail investor (or “dumb money”) has not jumped on the bull market bandwagon means that this is the real deal. After all, secular bull markets are known for pulling out of the station and leaving all but the most savvy investors and traders behind. And as contrarians, we want to zig where the crowd is zagging. So let them shiver, coiled in the fetus position, terrified of the last (and past) bear market. This is a new dawn. A new day.

Bearish
On the other hand, if you are bearish, you would point out that retail participation is vital to create momentum in a trend. Unless the US retail mutual fund investors start to believe in a bull market, there won’t be a bull market. After all, if the considerable amount of money sitting in fixed income is not used to bid up equity prices, how will we create the virtuous cycle of higher prices (which pulls in more money and so on)? Every secular bull market feeds on this self-perpetuating mechanism.

Could it be that this bear market left a traumatic mark on the psyche of the average US investor? If so, then this generation of investors will simply not be the same. We know from previous brutal bear markets that while the wounds heal, the scars are not forgotten. The generation that lived through the Great Depression continued to distrust banks, the stock market and all manner of ’speculation’ even after the US economy righted itself and went on to new heights of prosperity.

Let me know what you think
In any case, those are my thoughts. What do you think accounts for this aberrant behavior of the US mutual fund investor?

It looks like the worst may be over for the stock market. And while a ‘double dip’ may be just around the corner, for now it looks like retail investors are once more ready to take on risk. But are they actually ready to bet on higher stock market levels or are they simply trying to be opportunistic?

A recent article in the Wall Street Journal explored this question.

August is usually a slow month for both retailers and institutions with a 10% expected average drop in volume. But this past August brought with it an abnormal increase in trading volume. The majority of online brokers had increases of 14% to 18% in daily transactions. As well, the aggregate daily trading volume for Schwab (SCHW), TD Ameritrade (TD) and E-Trade (ETFC) show a robust increase not only from the past month but also compared to the past year (see left chart).

While there is still a massive pile of cash sitting on the sidelines, we aren’t seeing it being funneled to the equity market aggressively by mutual fund buyers. They continue to send the majority of their money to ’safer’ bond funds by a 20 to 1 margin (in August equity funds took in about $2 billion while bond funds absorbed $40 billion).

Gauging daily trading volume across online brokers is one method to measure retail investor mood. I use another which is much easily available and one which I’ve dubbed the Sheeple Index. It is a measure of the traffic activity for the websites of major online brokers. The logic is that we can see the footprint of the retail investors as they log on to make trades.

It isn’t a perfect indicator. For one, there is an inherent seasonality to internet traffic, much like the stock market’s volume which wanes in the summer. But it is a good enough metric because while there are still a tiny, sliver of a percentage of people who place trades over the phone, nowadays, the vast majority of people (including grandparents) are using the internet. As well, the traffic for the brokers which I measure are used by retail traders primarily. I ignore those preferred by more active or professional traders.

Having said that, there is no accurate way to measure the traffic of a website other than having direct access to its logs. There are a few third party sites which have taken different approaches to try and approximate this data but they each have their own weaknesses. As well, it must be noted that even if we could somehow measure the activity accurately, we would still have no way to know if what we are seeing is new money being put to work or just ‘churning’ in the account.

Below, I’ve shown several graphs of website traffic for online brokers. I’ve kept the colors consistent across the different graphs so they are easy to compare. The first is from Compete.com:
Continue reading ‘Are Retail Investors Really Coming Back?’

Well, it is the end of another year. And if you are a trader, your thoughts turn invariably to the January effect and more specifically, how you can use this phenomenal annual pattern to generate alpha.

There are a few ways to take advantage of the January effect. My personal favourite is on closed-end funds (CEFs). I’ve outlined the whole trading plan here: My Year-End Strategy.

With the turmoil in the bond market this year, a lot of bond funds and other “yield” vehicles have gotten beaten to a pulp. Which means there are a lot of unhappy longs who are selling for tax-loss year end reasons.

I feel like a kid in a candy store this year.

I’ll just feature one example: BlackRock Municipal Bond Fund (BBK), but for a vowel, my namesake. Almost everyone who bought this this year is facing losses:

Notice the upsurge in volume - a telltale sign. And the way it has fallen to technical support at $14.

Hope you had a great year, and see you in 2008