Trader’s Narrative

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?’

Money market asset levels fluctuate much less than their equity counterparts. The general trend for cash holdings is to increase steadily every year. There are some cyclical effects for bear and bull markets. As people become fearful in the face of a bear market, they horde money and as the become convinced they are losing money by not being invested in a bull market, they reduce their cash holdings.

This bear market has given us a lot of unprecedented market situations. We are now seeing a rare exception to the norm of equity fund assets dwarfing money market assets. This has been caused by a double whammy. As the stock market has been pummeled mercilessly, losing 60% of its value since late 2007, the asset value of equity funds has shrunk. And on the other side of things, retail and institutional investors consistently raised their cash assets. In September 2008 I pointed out that there was an unmistakable stampede towards cash as retail investors hoarded cash. Not surprisingly then, in November 2008, we saw a rare occurrence: more assets sitting in money market funds than in equity mutual funds:

Source: Bloomberg Chart of the Day

The last time this happened was 16 years ago, in September 1992. The data for April isn’t available yet but I’d bet it shows money market fund assets almost equal to equity fund assets. Not because people have put the cash to work but because the market has been able to hang on to gains and thereby increased the value of the equity assets.

But as Jason Goepfert of SentimenTrader points out, this is not an automatic buy signal for the market: A Major Buy Signal! Well, Maybe… All we can definitively say is that there is a massive load of cash just sitting on the side, waiting.

A build up of cash is normal in a bear market but before we can transition to a bull market it needs to be put to work. As people become convinced that the worst is behind us, they start to take more risk and begin to put their cash into the market. So unfortunately, just noticing a massive pile of cash doesn’t really help us unless we can somehow pinpoint when and with what intensity this billowing mass of liquidity will start to be invested in the stock market.

But to give you an idea of the sheer monstrosity of the potential tsunami of cash, consider this: it currently represents 50% of S&P 500 total capitalization. Needless to say, that is jaw dropping. As it is put to work, even in a trickle, it will put an impregnable floor on almost all equity indices and then drive prices higher. When that may be, can not be determined by this metric itself but by other technical, monetary and sentiment measures.

Limited Time 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.

Book Giveaway
If you haven’t already, throw your name into the hat for a giveaway of:
An American Hedge Fund.
The contest will close this Friday.

Welcome to 2009 and the first trading day of the new year!

The last sentiment overview of 2008 didn’t paint a pretty picture. And it seems that things have continued to deteriorate from there.

CBOE Put Call Ratio
Here’s a chart of the 15 day simple moving average of the CBOE put call ratio (equity only):

Unless you zoom out you will miss that in the past few years this indicator has fallen into a rather clear upward channel. In light of this channel, we are now very close to a bearish low for the put call ratio. As you can see, in the past this has coincided with very weak markets going forward.

ISE Sentiment
Surprisingly, just before the stock market got a year end boost - the S&P 500 rising from 870 to 930 - the ISE Sentiment index reached 206 on December 29th 2008.

The last time the ISE Sentiment index was close to this level was back on October 29th 2007 when it reached 192. Before that, the last time the call put ratio was above 200 was in May 2006, just before the market entered a period of weakness lasting until October of the same year.

If we look at the equity only ISE Sentiment data, the recent top came on the second to last day of trading of the year, on December 30th 2008 when it reached 234 - meaning that retail option traders on the ISE exchange bought over twice as many call options as put options. The last time this bearish level was surpassed was in October 2007. So obviously this is an ominous warning for anyone who is long this market.

Here’s a chart of the ISEE sentiment ratio (equity only):

Silver Lining
The only bright spot I can find in sentiment land is the recent data regarding portfolio allocation from the AAII. I’ve mentioned this before back in the sentiment overview for the week of October 3rd 2008.

According to the survey respondents at AAII, in October of last year, the retail investor in the US allocated 35% in cash, 51% equities and the rest in bonds. They have now moved to 42% cash and only 42% equities (and the rest in bonds).

This is significant because for the whole history of this indicator, retail investors have never allocated as much (or more) cash as equities. Clearly, this shows a despondency which contrarian investors spend most of their days sighing for in vain.

Although we have now surpassed any historical equivalent of an extreme for this sentiment indicator, it is interesting to note that the last two times that the allocation for cash and equities came close (but didn’t match) was in late 1990 and late 2002. Both brilliant spots to put cash to good use.

This dovetails well with some other reasons already outlined for long term optimism. It seems that we are in for a rough patch in the short term but clear sailing for those who will grit their teeth and bear it. No pun intended

As opposed to just a few weeks ago where I had to scrape bits and pieces of information to put together a sentiment overview, this week we have an over abundance of data and indicators, so lets get started:

Hedge Funds Net Short
Based on information from Carpenter Analytical Services, the average hedge fund was just until recently net short to the same degree as mid 2004 and early 2003. I’d suggest taking that with a grain of salt because hedge funds are by their very nature nebulous and non-transparent. Carpenter “reverse engineers” hedge fund positions starting from their performance. While this metric is far from 100% dependable it does provide limited insight into how the brightest traders are positioned.

More important than the snapshot of hedge funds being net short, I’d like to see the market continue to go lower, or level off, while the hedge funds aggressively change their posture and go net long. This is what we saw in mid 2003 just before the S&P 500 took off like a bottle rocket from the bear market depths it had sunk to. On the other hand a dangerous situation brews if the market continues to meander or even manages a feeble rally while hedge funds continue to aggressively bet against it.

Cash Is King
Combined with the net short positions, hedge funds are strangely hiding a significant amount of assets in cash. According to analysts at Citigroup, hedge funds have now socked away $600 billion in cash with $100 billion of that in money market funds. This is highly unusual because assets are invested with hedge funds with the view that they will be invested in the most sophisticated methods allowing for market neutral returns.

The extreme cash position is a sign of temporary uncertainty as the whole market seems to be news driven now. It may also be a result of the new short sale restrictions (although hedge funds can easily circumvent them, it may not be politically expedient to do so). On the plus side, it represents a formidable force that is being kept in reserve, if and when the bull market resumes.

The massive cash horde is also matched by the mutual fund industry with the average equity fund (non-index) holding 5.4% of assets cash. According to Morningstar, this is slightly below the record of 5.5% set in late 2007.

ISEE Sentiment Index
Last week after pointing out that the ISE options sentiment was acting strange, the ratio started this week with a jump to 136 (from a low of 66). As retail option traders rushed to buy call options over put options, the market tumbled down ~1255 (S&P 500 Index). I continue to wait for this indicator to give us a true showing of fear from the retail option traders. We came close last week but with this week’s recovery in the ISE sentiment index, unfortunately, it seems we will have to muddle through until perhaps we see a sharp waterfall decline take us through to real panic.

CBOE Put Call Ratio
This option metric is also showing a muddled picture. As I mentioned briefly last week, the CBOE put call ratio fell to 0.51 but since then it has quickly recovered, as if all the talk of financial Armageddon is simply being ignored by main street investors. This level of complacency is not something that gives a contrarian much confidence that this new found stability in the market holds promise.

Corporate Insiders
From the Vickers Weekly Insider Report, corporate insiders continue to act bullish in the face of the market decline. The ratio of insiders purchase and sale of company stock is as bullish as it was in mid July 2008 and towards the end of the bear market in 2002. Although this is a reliable and quantified indicator (as opposed to bearish or bullish sentiment) it should be projected into an intermediate time frame and not used to make short term trading decisions.

Sentiment Surveys
According to the American Association of Individual Investors (AAII), there is less pessimism this week with only 45.74% bears and slightly higher bulls 34.04% (than last week). I’m not happy to see this because the market is actually lowered than where it closed last week! So to see an uptick (even a small one) in bullish sentiment is disappointing… if one expects this to be the floor for the market.

The Investor’s Intelligence sentiment survey which measures where newsletter editors stand (as judged by ChartCraft) is little changed with 37.5% bulls, 40.9% bears (a slight decrease).

Mark Hulbert, of the Hulbert Financial Digest, suggests that the best performing market timers are significantly more bullish now than their less astute peers. This may seem to be a bullish sign but for the fact that the top performing market timing newsletter editors have been more bullish for most of the market decline. The key, I suspect, is to watch for the deviation between the two camps to widen to a significant enough gap to merit contrarian attention.

Conclusion
The mood is discernibly grumpy on Wall Street. And the financial sector is not the only one to be punished mercilessly. Take for example, Research In Motion (RIMM) which announced earnings that barely managed to disappoint due to slightly higher expectations. Even though they are a profitable company, they were taken behind the shed with a an almost 30% decline in one day!

Having said that, considering the historic and unprecedented situation, it is unusual to not see every single sentiment indicator not stuck at its most extreme reading possible. Arguably, we still have not seen full blown panic selling to completely wash out all the weak hands.

Depending on the framework you use to understand the market, at times it is possible for the market to be “confused” or even “wrong”. Of course, according to some, the market is the perfect amalgam of all relevant information so that isn’t possible.

But then again, any student of the financial markets can easily call up many examples where the market exhibited what can perhaps be best described as collective temporary insanity.

As I look across this market, checking the advance decline breadth, the highs and lows, the VIX, put call ratios, and all the other technical indicators, I can’t shake the feeling that it is a bit confused. Or perhaps, it just can’t make up its mind and is trying to hedge its bets as best as possible.

Just look at the past few trading days! Up, down, up, down, up, down… ending up at pretty much the same place we started.

I’ve been accused of having a penchant for the bullish side so I’m trying to be more than careful in scrutinizing the weight of the evidence, on both sides. And for the most part, there is really no compelling reason to be in either camp right now.

Maybe (gasp) the retail investors are right and cash is the best spot right now.

The market certainly feels heavy, but while intuitively I think it wants to go down, I don’t see any strong reasons to push it down with my own measly contributions.

Here is a snapshot of the sort of thing I mean. This chart shows the percentage of S&P 500 stocks trading above their 10 day moving average. Notice how in mid July, as the market was pulled sharply lower, this very reliable indicator (check out the research report from Lowry’s), did not perform its usual magic:

Is it too much of an obvious to say that this market is being driven by the financials? They were responsible for the mid July spike down in the behemoth S&P 500 Index. Pull up a chart of the 90 day Treasury Bill and you can see the epicenter of the quake that shook the markets.

I’ll go more in depth in tomorrow’s weekly sentiment overview and we’ll see if we can make any sense out of this crazy tape.