Trader’s Narrative

Bear market? credit crisis? It seems that both retail and institutional investors have for the most part either forgotten what happened just a few short months ago or convinced themselves that if everything isn’t fine, it will be (if they just wish hard enough).

For more economic and market news and to see what interesting reading you may have missed last week, check out the list below. To see it all go to news.tradersnarrative.com:

• Cap-and-Trade’s Unlikely Critics: Its Creators
• Are We in a Bull Market Yet?
• RBS Strategist & Uber-Bear Issues Sell Alert
• Three Bad Reasons for Pursuing Trading as a Career
• Get a FREE Subscription to Futures Magazine
• The most accurate predictor of inflation
• Deflation Now Visible in China
• Soros: US Economy Has Bottomed
• Dow Theory Buy Signal
• The Dead Parrot of Finance
• Sun Tzu: Art of Trading
• Get the “Best of Trader’s Classroom” eBook for FREE (limited time)
• Your Brain Thinks Money Is A Drug

For the complete list, follow the graphic link below:

And remember to check back regularly since there are interesting links added throughout the week.

Week Ahead: Housing Data & Earnings

Let’s take a quick look-see at the sentiment for this past week:

ISEE Sentiment Index has backed off the low extremes considerably and hit 125 - so retail option traders are buying slightly more calls than puts. This is to be expected and unless we see this indicator reaching +200 the rally shouldn’t be in danger.

Short interest ratio is the number of shares of stock sold short compared to the average daily volume. On the NYSE, this ratio is close to 9. By itself this would be astonishing because it is the highest ratio in history. But there is more going on than simply rampant shorting of stocks. A new structured fund product has taken off on Wall Street, sucking in billions of dollars to a long/short strategy.

The AAII sentiment has ameliorated slightly with just 49% of retail investors feeling bearish this week. But still only 30% are bullish, leaving us with quite a bit of left over panic.

LowRisk’s 30 day outlook continues to be mired in absolute dejection: 59% bearish and 36% bullish. The remarkable thing is not only the degree of bearishness but that there are so few fence sitters (only 5% are neutral).

The troublesome Investor’s Intelligence sentiment continues to back off its bearish signal of the last few weeks. This week bulls are only 40% - a level we reach at intermediate market bottoms. The past few times we got this low were: summer 2004, summer 2006 and August 2007. Having said that, we still are not seeing any sort of panic in newsletter-land.

The Hulbert Stock Newsletter Sentiment index is mirroring the II picture with only an average of +10.1% exposure recommended by stock market timing newsletters. Seeing how the historical maximum is +79.7% and the minimum is -81.8%, things are decidedly lukewarm. But Mark Hulbert, keeper of the HSNSI interprets the concomitant rise in bullish sentiment with market prices to mean that the rally is hollow and bound to retest the recent lows.

Recent Yahoo! (YHOO) holders are all too familiar with a retest of lows. That is, before this morning’s surprise announcement from Microsoft (MSFT) regarding their amorous intentions. If you were holding YHOO, I hope you took at least some money off the table.

UPDATE: Its been a while since I mentioned the TickerSense blogger sentiment poll but I just noticed that the bulls are at only 24% while the bears are at 44%. This is the highest disparity between the two camps since March 12th, 2007 when bloggers were 13.16% bullish and 42.11% bearish.

I’m a bit wary of giving this too much weight because of the edgeless nature of this particular sentiment indicator. But if you notice, there’s been a remarkable switch since last August: bulls have been more predominant than bears. So now, after months and months, we see the bulls finally capitulating. There may be something in that pattern.

A quick follow up to gold and gold stocks:

Although both the yellow metal and related equities have continued to rise, something is conspiring to keep a tight lid on the rally. And no, it isn’t a wide reaching and vast conspiracy involving central banks, hedge funds, the Easter Bunny and Mossad.

Last week, gold sentiment skyrocketed to 81% - as measured by MarketVane’s Bullish Consensus. That is the highest it has been this year and not too far off historic extremes.

According to contrarian analysis, there is way too much excitement about this little latest rally. When the vast majority of those who are interested are bullish (and act on the opinion by buying) the tragic conclusion is that there isn’t any real buying pressure left to propel prices higher.

This is what happened last May when bullish gold sentiment reached a crescendo of +90%. Gold peaked at $725 and the AMEX Gold Bugs Index (HUI) at 400. Neither have seen those levels again. And if the bullish sentiment continues, there is less and less probability they will.

The only argument that I can see for a continued rally in gold is the bullish percent index for the sector. According to the BP index kept by Dorsey, Wright & Associates, there is a possibility that we could see gold break out from this multi-year trading range.

In mid August, along with the rest of the market, gold got clobbered. That caused the bullish percent for the index to fall to 16% - a very, very low number. So far, it has recovered from this depth to 30%. As you can see from the chart (below), the BP index has quite a ways to go before it reaches overbought territory.

So take your pick: keep gold longs because bullish percent is still quite low or pare positions and tighten stops because sentiment is getting too bullish. Personally, I’m going with sentiment - via contrarian avenue.

Click To Enlarge Graph:

Graph Credit:Technical Watch

Thanks to Moises, a reader in Barcelona for the link (please have a bocatta on me and don’t forget the tomate drenched pan)

The sentiment overview for this week in the markets:

Sentiment Surveys
The usual suspects: AAII, Investor’s Intelligence, LowRisk, Consensus and Market Vane did not vary significantly over this past week so I won’t go into detail.

ISE Sentiment Index
Although technically a measure of options activity (ratio of puts to calls), the ISE Sentiment Index (ISEE) reached a 32 trading day high yesterday at 151. Today’s reading hasn’t been release but going by the intraday data, my guesstimate is in the high 140 range (UPDATE: 154). The 10 day moving average of the ISE put/call ratio has reached 118, well off its multi-year low in the 90’s range - where it gave a wonderful signal to mark the inflection point.

Magazine Cover Stories
This unusual sentiment indicator only gives signals sporradically but when it does, it pays to take notice. In August there were multiple negative cover stories. Here are 3 that I caught:

Notice the liberal use of the color red (with its obvious and subconscious connotations). Also, the Economist cover art not only shows a surfer, perilously hanging ten - about to be engulfed by a larger wave behind him - but those grey specs are four sharks in the water waiting for the inevitable.

The last time I featured a negative Economist cover was last summer when they ran a photo of a bear in the woods, just as the stock market was in the middle of its correction. The swoon lasted another month and prices dipped slightly lower than when the cover story appeared but clearly the worst was already over.

And lest you think that cover stories only have contrarian power when they are bearish, consider the glowing Akamai cover story in Forbes magazine in mid-April when it was trading around $50 a share. Now it is scraping $30.

A little late due to travel, but as they say, better than never…. here’s the sentiment recap for the past week:

AAII
Still too many bulls in this sentiment reading (40%) but the bears are still outnumbering them at 46%. There’s no denying that during this correction the Mom’n'Pop retail investors have come across as outright cold-blooded creatures. My own personal theory is that they simply don’t care about the stock market because they have very little invested and therefore, little at stake.

Investor’s Intelligence
No real change in this indicator. The newsletter writers are pretty much where we last left them last week: about equally split between the bulls and bears.

I’m a bit puzzled why this sentiment indicator is so flaccid. Especially when you consider that according to Hulbert, newletters are rather spooked (see below). My hunch is that Chartcraft and Michael Burke (editor) have a slightly different interpretation of newletter writer’s intentions. You have to remember that unlike many of the other sentiment measures, this one involves a subjective call which categorizes the letter as bullish, bearish or neutral.

Hulbert Stock Newsletter Sentiment
The HSNSI closed August at +5.5%- this means that for the newsletters that try to time the market in the short term, they are on average only recommending being 5.5% long this market.

Although this measure has risen from about two weeks ago when it reached -11.3%, it still provides us bulls with some ammunition. That’s because in the face of a ~600 point rally in the Dow, the newsletter timers have only dipped their toes into the stock market.

Had they rushed in wholesale, things would be different. But they are obviously still timid and only reluctantly admiting that the market isn’t all that bad after all.

Consensus
Consensus bullish sentiment reacted sharply to the market’s gyrations by jumping 7% last week. It had plumbed depths that it had only seen before during last year’s August correction.

Market Vane
In contrast, Market Vane hasn’t really budged. At 53%, it is still quite low. And although I referred to an interesting interpretation of its recent behaviour during the last weekly sentiment review, I still think it should be interpreted from the traditional upside down, contrarian point of view. So nothing new here.

Massive Doomsday Options Trade
Finally, I wanted to touch on the story that has been making its way around the internet, trading discussion forums and even CNBC: that a massive options trade has been put on which predicts that the market will crash in the coming months.

The details of the story are pretty much everywhere. I found mentions even on digg and reddit. Ugly mentioned it a while back when it was just going viral. Make sure you also check out the discussion in the comments section.

When I heard it, I must confess, it made me chuckle.

Would anyone really put on a one sided options bet like that? and would they do it via the very public options market rather than the more private swap market?

If you believe this conspiracy theory, you need to get in touch with me stat. I’ve got a wonderful bridge in Estonia to sell you for a very reasonable price.

But seriously, this sort of doomsday story goes viral because it feeds on people’s fear (and ignorance). And that is a truly insightful contribution to sentiment.

Since over here we practice contrarian analysis when it comes to sentiment, this is exactly the sort of brick that walls of worry are built from.