Trader’s Narrative

At the start of the week we contrasted the strange pessimism that has gripped the US retail investor to the levitation act of Wall Street. It is almost as if Wall Street threw a party and other than institutional investors, a few day traders and algo quant jocks jamming high frequency trades, no one else showed up. If you ask Paul Desmond, of Lowry Research, this is a real bull market that will last another 3 years.

With all due respect to Desmond, today I wanted to entertain some bearish counter arguments to temper that cheery outlook and delve a little deeper into the market condition both in the short and longer term.

While considering the same ICI fund flow data, it is conceivable to come to bearish conclusions. Take for instance the fact that domestic equity funds have attracted less than $8 billion of fresh capital since the lows in March. Had this rally provoked the same pattern of retail investor participation as previous ones, we should have seen $150 billion flow to equity mutual funds, according to TrimTabs.

Maxims ad Nauseum
While it has become an accepted maxim repeated ad nauseum that a bull market likes to climb a “wall of worry”, the historical evidence is otherwise. The stock market actually tends to float higher on gradually increasing levels of optimism - until that optimism reaches a crescendo and then the whole thing unwinds. And we start all over again. So generally speaking, the stock market performs better following periods where there are net inflows of funds.

Whether retail investors are acting intelligently by avoiding this rally or more accurately, by selling this rally, is something that only history can answer. It isn’t hard to imagine though, the possibility that they are reacting emotionally. Think of it. Having first experienced severe loss in their portfolios and watching Wall St. insiders ride on a cushion of bonuses, insult is added to injury when they have to fend for themselves in a new harsh economy.

What if we are seeing the rejection of the great “equity culture” and the almost religious belief in “buy and hold”? What if the record inflows to bond funds are being driven by a traumatized populace seeking the one shelter of income investing?

So far, this has been so relentless that it has pushed the fixed income share of US household wealth above 6% once again. But if you notice, the last time there was a similar increase happened during one of the strongest bull markets in equities:

However, what is undeniable is that if the US retail investor doesn’t return to equities eventually, what we could see is another lost decade; where markets flop around like a dead fish, but don’t really go anywhere. This is what happened before the great super-bull market was launched in 1982.

The completely stark scenario is one where retail investors continue to ratchet up their sales of equities and push the stock market lower as a cascade effect takes place where gloomy sentiment and fear feeds on itself. Think of it as the great unwinding; or the negative wealth effect.

Technical Weakness
Returning to more present and short term matters, the market came perilously close to the invisible 20% distance from its long term moving average. Yesterday I mentioned that stocks have little room to the upside and while I’m not surprised to see the weakness today, it by no means guarantees that we won’t see a final push to 1120.

On Monday 94% of the S&P 500 stocks closed above their 10 day moving average. That’s the highest since mid July. Since then this measure of breadth has backed off slightly but is still hovering above 90%. Other negative technical considerations are that prices are pressing against the downtrend line at 1100 - from the top of the bear market (in October 2007). And that other major market indexes like the Nasdaq, Russell 2000, the Philadelphia Banking Index (BKX) and the Semiconductors (SOX) are still below their previous swing highs. Finally, volume continues to be anemic as it has been for most of this whole trip.

Last week I presented a historical study of what happens when the S&P 500 is this far away from its 200 day moving average. If you missed it, click the link to check it out in full.

According to the study, when the stock market has trended enough to set off this indicator, it has trouble continuing its heady ways in the months that follow. The average 6 month return is -5%.

If you look at the data carefully, it becomes apparent that certain date ranges contain a lot of repeated instances where the S&P 500 index is 20% or more above its long term moving average. We’ve just traversed one of these periods from September 16th to the 22nd. Between those dates there were 5 consecutive days were the S&P 500 was at this threshold (or very very close).

The last time this occurred was at the end of July 1997. But the best example was of tenacity in this indicator was in late 1982, just as the great generational super bull market was launched. Although the expected consequence of such an overbought condition is for the market to hit a wall, or at least to pause, during the start of the great bull market, this was not the case. While it continuously flashed red, the stock market continued to climb higher and higher, acting very out of character.

So the question is whether what we are seeing is a repeat of that atypical market action. In other words, do bull market rules apply?

Although there is no way for me or anyone else to prove it definitively one way or another, I highly doubt that what we are witnessing is the dawn of another rare secular bull market based on one variable: valuation.

I mentioned a lot of ratios, statistics and data before but putting all those numbers aside, here is a simple chart which sums up the strange voyage we have taken, from fully priced perfection to panic induced forced liquidation and back again:

That doesn’t look like a great launch pad for the next generational bull market. Heck, even bonds are priced for perfection. At best, we are going through a cyclical bull market - otherwise known as a bear market rally.

Here is the round up of sentiment data for this week:

Sentiment Surveys
According to the weekly AAII sentiment survey, US retail investors are pretty much split evenly between the bullish and bearish camps. The bulls are at 42% ( that’s a 5% point increase from last week) while the bears are at 40% (4% point decrease from last week).

ChartCraft’s Investor Intelligence measure of stock newsletter editors has taken the bullish mantle from the retail investor’s survey for several weeks now. And it continues this week as well. The latest II poll shows the bulls commanding a 47.8% share of the respondents (down slightly from last week) and the bulls, 24.4%. The simple bear/bull ratio continues to run at about 2:1 - giving contrarians a clear signal.

German ZEW Survey of Investor Confidence
Turning our attention to the other side of the pond, the German ZEW sentiment survey of investor confidence (green line in chart below) came in slighly short of the 60 expectation but still managed to climb to 57.7 - its most bullish level since April 2006. However, the survey’s “current economic” outlook - while slightly off its recent lows - is still mired at historic depths (blue line):

This month’s survey results mark one of the few times in the history of this statistic where there is a large mismatch between the two measures. While the current economic situation is still deemed to be very poor, confidence in the future is very high. This should be familiar as it is the same tune that everyone is humming in the US markets. The question then is what happens if the rosy expectations of the future do not come about?

Option Traders
Both the CBOE put call ratio and the ISEE index are showing an excessive bullishness. This should be normal but since they have disagreed with one another so much, it made me sit up and take notice.

The CBOE put call ratio (equity only) dropped to a low of 0.45 earlier in the week (Wednesday - September 16th, 2009). That’s a lot of call buying! The short term moving average of the daily put call ratio continued to decline as it has for the past few months. It is already below its long term channel so it is difficult to determine what if any sort of signal it is giving now.

The ISEE index (equity only) meanwhile jumped to 242 on Wednesday’s long range candlestick. That means for every 100 puts, 242 calls were bought (to initiate a position). To find a more bullish one day statistic, we’d have to hop into our time machine and travel back to November 6th, 2007 when the ISEE index hit 245. At that time the S&P 500 was trading around the 1500 level. More important than just the one day spike, the 10 day moving average for the ISEE is now also significantly high as shown on the chart below:
Continue reading ‘Sentiment Overview: Week Of September 18th, 2009′

Equities, as an asset class are supposed to beat everything else in the long run. But how long is the long run supposed to be?

Is 10 years enough to be considered long run? For the past decade, equities, as measured by the S&P 500 index have been the worst asset class:

The ultimate shaming is that even a risk-free money market rate beat the dividend reinvested returns provided by US stocks. As for the other asset classes, they left equities in their dust. For me, the most surprising is the high return provided by long term government bonds. Of course, by far the best asset class was gold.

The last time we looked at this metric was in February (thanks to a chart from the New York Times). Then, the 10 year inflation adjusted return was -5.1%.

Here’s a chart of the S&P 500 index showing how we’ve see-sawed above and below the 1000 level more than a few times:

And while this is pretty horrific to anyone who was invested in equities for the past 10 years and actually expected the proverbial 10% p.a. return, it may not all be gloom and doom going forward. That’s because such negative returns over rolling 10 year periods are actually quite rare. Looking at a graph of the 10 year returns of the S&P 500 index, you notice that whenever things get this ugly, forward returns are very good. You can check out the chart in the commentary I wrote back in late November 2008: Why Long Term Investors Should Consider Buying.

That was written when the S&P 500 had an 8 handle. It dropped significantly lower so anyone with a long term time horizon would have gotten in early. But they would still be doing well right now.

Here is this week’s sentiment summary, bursting at the seams with sentimental goodness:

Sentiment Surveys
According to this week’s AAII sentiment survey, the US retail investor is becoming outright bold. The bullish crowd surged to 50% while the bears increased slightly (4% points) to 35%.

ChartCraft’s measure of the average investment newsletter editor’s sentiment - Investors Intelligence - also showed a similar level of optimism: the bulls increased 5% points to 47.2% while the bears fell 5.3% points to just 25.8%.

Rounding out the trifecta near or at 50% was Market Vane (US equities) at 46% bullish. That’s the most bullish it has been since May 2008 when the S&P 500 was trading at 1400.

Ned Davis Research’s proprietary sentiment indicator, called the Crowd Sentiment Poll stands at 62% - just eking into the extreme optimism range (anything above 61.5%). In the past this measure has reached highs of 68% which would give the sign for investors to sell weaker holdings.

Finally, Jake Bernstein’s proprietary sentiment indicator, Daily Sentiment Index (DSI) is also showing an extreme level of bulls. For the Standard & Poor’s 500 index the sentiment reached a high of 88% bullishness. The Nasdaq 100 sentiment was marginally lower at 87%. Needless to say, this is indicative of a short term top.

The DSI is uncommon, especially outside professional settings. Partly this is because Bernstein keeps the method and calculation a secret but also because it is an extremely expensive report. But what I’ve heard from trading friends, it is well worth it as it has just about nailed the exact inflection points at every major move.

Fund Flows
In last week’s sentiment overview we briefly touched on the gargantuan amounts of cash sitting on the sidelines of the market. While we’re now seeing flows out of cash only a small fraction is going to equities.

In fact, it would be accurate to say that the powerful spring rally has been mostly driven by institutional traders and investors with very little juice coming from the retail ‘Mom and Pop’ investor. According to the Investment Company Institute (ICI) small investors have only poured in $4.1 billion into the equity markets (for July). That’s chump change, especially when we compare it to the flows from cash to bond funds which stands at $28.8 billion. More on the bond market below.
Continue reading ‘Sentiment Overview: Week Of August 7th, 2009′