Trader’s Narrative

It is the end of the week and so we take a stroll through the sentiment meadows:

Investors Intelligence
This week the ChartCraft measure of stock newsletter editors sentiment was little changed from last week: 49.5% bullish and 23.1% bearish. That’s another week where twice as many are optimistic that the stock market will continue to rise. A remarkable long string of weeks but so far they have been correct.

AAII
The US retail investors meanwhile, as measured by the weekly AAII sentiment poll are slightly less confident. There was a 6% point fall to 41% bullish. And the opposing camp increased a smidgen to 36% bearish. All in all, this metric is slightly elevated towards too much optimism but still not enough to warrant our full attention.

Hulbert Stock Newsletter Sentiment
The Hulbert Stock Newsletter Sentiment Index (HSNSI) which measures a subset of newsletters which try to time the market continues to be muted. For the most part the HSNSI is showing skepticism in the face of the continuing rally. The HSNSI is about as bullish as it was back in April 2009 when the S&P 500 was trading at 800 - some 280 points lower. That is to say the average market exposure recommended by market timing newsletter is only 32.3% (long) - slightly lower (by 2.3% points) than what they were recommending 6 months ago. Such an unflappably consistent skepticism in the face of a gravity defying rally hardly gives the bears much ammunition.

Consumer Sentiment
The preliminary October results for the Reuters/University of Michigan consumer sentiment index fell to 69.4 (significantly lower than the consensus estimate at 73.4):

During economic contractions, the average Michigan consumer sentiment is 74. The average during economic expansions is 91. And on average when the S&P 500 has rallied 60% from a recessionary low, this consumer sentiment reading is 90.5. These historical patterns offer a remarkable contrast to where we are today - especially if we consider the often repeated mantra that we are in full blown recovery mode.

Option Traders
The 10 day simple average of the ISE sentiment index (equity only) call put ratio has an enviable track record - in the intermediate time frame. Almost every time it has reached 200, the stock market has meandered then stumbled. Not at all surprising since this implies that for the past 10 trading days, relative to puts, more than twice the number of calls have been purchased to open an options trade. Not once has the stock market been able to muster a significant rally when we’ve seen this metric reach such an extreme reading.

So it is important to sit up and take notice as this week the 10 day average for the equity only call put ratio floated up to 200 and on Thursday hit 202. During the relative short history for this sentiment metric, here are the few times where it has been above this mark:

The first was at the start of 2006 - the S&P 500 plateaued then fell into the summer. It wasn’t until September 2006 that it had reached a new high for the year.

The next instance was late in 2006. This was not the best signal since the market did manage to continue to climb momentarily. By March 2007 the S&P 500 was back at the same level.

Then it was May and October 2007 when the ISE’s 10 day average again touched 200. During that time frame the market did manage to push against the tide but over all it went nowhere. And we all know what happened after that.

CBOE Put Call Ratio
In contrast, the CBOE put call ratio (equity only) has recovered smartly from the call buying frenzy that we witnessed last week. Although we’re seeing the bulls reign in some of their enthusiasm for calls, it is important to note that from a long term perspective, we are still seeing a preponderance of hope and optimism rule the option pits:

Fund Flows
Last month we looked at the remarkable trend in fund flows for US retail mutual fund investors where even after a 60% rally in the S&P 500, the love affair with bonds continues at the expense of equity mutual funds.

Since then the same trend has more or less continued. Bond funds are still getting the majority of investors money but this week the ICI estimates they only got $8.80 billion (while last week it was almost double that at inflows of $15.21 billion). Equity outflows meanwhile have ameliorated with an estimated $3.39 billion being withdrawn for the week. This is down by about $1 billion from last week.

While a portion of this trend can be explained by the massive number of retail investors who are approaching retirement age, I can’t believe that that is the whole story. This bear market left a traumatic and indelible mark on those who lived through it, either as traders, investors, professionals or mere mortals. If this is true, then going forward, this means that we have to be very careful in how we calibrate our most trusted sentiment gauges.

If it is Friday then this is the week’s sentiment round up:

Sentiment Surveys
If you’ve been monitoring the mutual fund flow data, you wouldn’t be surprised to see the AAII continue to show the average US retail investor as decidedly unimpressed and cool about the rising stock market. This week the pessimist camp grew slightly to 41% while the bulls shrank by 9% points to 35%.

The latest Investors Intelligence bulls edged off the half way mark to 48.9% while the bears increased slightly to 24.4%. This is nothing really noteworthy by itself, except to mark the continued 2:1 bull to bear ratio we’ve been seeing for the nth week. So far, the market has not succumbed to this flashing red light and it is anyone’s guess when it will finally decide to do so.

I mentioned the NAAIM Survey of Manager Sentiment as a lesser known sentiment measure at the start of the year. And it is time we updated it to see what it can tell us about the mood of active investment managers in the US:

At the end of September the NAAIM was +86.41 and has since dropped slightly to 68. It is difficult to see in the chart above, but the last time this sentiment measure showed as much bullishness was back in - Yikes! - October 17th 2007 (when it was +86.93). And it was surprisingly, even higher earlier in that year when it reached +90 in January, February and May 2007.

The RBC Consumer Attitudes and Spending by Household (CASH) survey jumped 11.8 points to 51.8 in October - this, after falling to an all time low of 1.6 in February 2009. The monthly RBC Index measures consumer attitudes on the current and future state of local economies, personal finance situations, as well as their savings and confidence to make large investments.

Finally, Consensus which measures futures traders shows them to be 72% bullish. Once again, raising the hairs on your back, that’s the highest level since October 2007.

Option Traders
The puts and calls are flying furiously but there is a definite skew as option traders favor the bullish side of the derivatives. Both the ISE and the CBOE measures of option activity show a continuing crowding on the long side.

The ISE sentiment index (equity only) closed at 221 this Friday, implying that more than twice as many calls were purchased to open a trade as puts. Meanwhile, the CBOE (equity only) put call ratio fell to 0.47 on Tuesday - among the lowest single day ratios for the whole year… so far.

Rydex Traders
But the itchy trigger fingered Rydex traders have suddenly gotten cold feet. Even as the market has recovered smartly from its latest set back, the Rydex Nova/Ursa ratio has fallen as these short term market timers eschew the long side:

Conclusion.
Cross currents in sentiment are completely normal and something that any contrarian has to get used to. However, the current market’s sentiment conditions are especially confusing as it seems that one measure simply contradicts the one before it. When you don’t see an edge, don’t push your luck.

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.

There’s much to cover in this week’s roundup of sentiment data, so let’s dive right in:

Sentiment Surveys
The American Association of Individual Investors’ weekly survey of sentiment doesn’t show much change. About 39% think the market will go higher - that’s 3% points less than last week - while 45% think the market will fall - that’s a 5% point increase from last week. All in all, the AAII survey hasn’t given us a signal definitive signal since August when it blinked red (excessive bullishness) and earlier in March when it blinked green for excessive bearishness.

The Investors Intelligence survey of newsletter editors on the other hand continues to insist that there are about twice as many bulls as bears: 46.7% bullish and 24.4% bearish. We’ve seen a gentle amelioration in the optimism from last month but still, 2:1 is rather extreme.

Since we’re slicing and dicing sentiment through various surveys, why not take a look at what the millionaires are thinking? The Spectrem Millionaire Investor Index and the Affluent Investor Index are the only one of their kind (if I’m wrong, let me know). Few wealthy investors are ready to jump back into the stock market. Right now they are fond of cash and growing fonder of bonds. While still very cautious towards equities, they have started to tip-toe back in. According to Spectrem, 70% believe a drop in unemployment will signal the end of the recession. So it seems the wealthy are not all that different from the unwashed masses - at least when it comes to their portfolio.

Michigan/Reuters Consumer Confidence
US consumer confidence continued to rise reaching 73.5 - much higher than the expected 70.5. This is the highest level of consumer confidence since January 2008 - before the equity and credit markets cascaded down in a devastating decline. The index of future expectations continued to recover as well, rising to 73 - the highest in 2 years.

This month’s Michigan/Reuters survey also provided for a very large jump in the “News Heard Index” which measures the ‘net’ bias of the good news and bad news that consumers hear. According to Credit Suisse’s chief economist, Neal Soss, the News Heard index has a very high correlation with monthly changes in consumer confidence. So maybe the US economy is starting to turn around. But even if it isn’t, if enough people believe it is, it becomes a self-fulfilling prophecy.

Rydex Traders: All In
This week’s weakness in the stock market has been enough to bring out the bargain buyers within the Rydex market timing community. Right now there are twice as many assets in the bullish side as the bearish side. Every time that we’ve seen this extreme in recent times, the market has either paused or corrected. For more information, see Guy’s blog: Technical Take.

Fund Flows Data
If you were reading the blog earlier this week, you caught the chart of equity vs. bond mutual fund flows. While it is still premature to label it a trend, the preliminary data shows that the average US retail investor is not being enticed to re-enter the stock market in the least. Not even by an astounding 57% recovery in the S&P 500. They are in fact withdrawing their money from equities and stuffing it in various bond funds. The anecdotal evidence points to a traumatized populace which has been burned so many times, it has simply decided to withdraw and not play a rigged game.

Other than the implications for stock market sentiment, which are many, this brings up another important point. Whatever the impetus for this rally, the mutual fund data suggests that the US retail investor is not it. So if the masses who were once weaned on “buy and hold” are not buying, and corporate insiders are not buying, who is exactly?

Option Traders
We patiently waited many months as the ISE and CBOE option data fed us mild gruel week after week. Now they are both showing excessive call buying as option traders push their luck that the stock market will continue to rise:

The short term average of the ISEE index (equity only) which measures retail call buying relative to put buying is now at 194. This means that on average almost twice as many calls were bought as puts to initiate a position by retail traders. The last time this indicator was at these lofty levels was in November 2007. The highest it reached during that cycle was 229 on October 15th 2007 just days after the bear market top.

And here is the chart for the 10 day moving average of the CBOE (equity only) put call ratio showing basically the same amount of excessive bullishness:

The confirmation that these two separate option sentiment indicators provides is welcomed, especially after so much time where they either disagreed with one another or didn’t flag any extremes at all. The message right now is crystal clear.

A few days ago we discussed the bearish implications of the S&P 500 being 20% above its 200 day moving average. A similar study from Quantifiable Edges based on the CBOE put call ratio data shows a similar outcome.

Gold Sentiment
Gold is once again flirting with the $1000 level. It has once again lost the four figure handle but from various sentiment indicators, we have good reason to expect this current charge to succeed in breaching the $1000 line for good.

The Hulbert Gold Newsletter Sentiment Index (HGNSI) is showing a surprising lack of excitement this time around in contrast to the other previous runs at $1000. The average exposure recommended by newsletters at previous tops was 62%. However, the HGNSI currently only stands at 39.5% (see article for more details).

The lukewarm HGNSI number dovetails with the other various sentiment indicators which I mentioned recently: Google Trends: Gold Sentiment Neutral and Various Perspectives On Gold At $1000.

Grey Beards
Let’s check in with the ‘grey beards’ - those that have either been prognosticating for a lengthy time or have been extremely prescient to win our admiration and attention. David Rosenberg continues to be unapologetically a non-believer in the current standing of the stock market. He recommends resource sectors, gold, other commodities and the Canadian dollar and Canadian government bonds.

The grumpy bear, Jim Grant has suddenly gone bullish. In a recent Wall Street Journal article Grant outlines his reasons for a more optimistic outlook.

Bob Janjuah of RBS is having none of it - as usual. He is back from vacation with a bah humbug!

All I see is growth and asset price gains driven by the willing and reckless destruction of government and central bank balance sheets.

Magazine Cover
From the contrarian perch, this week’s Business Week magazine cover is a confusing one. Because of the design, there are two covers in one that manages to be both bullish and bearish, depending on which side you hold up and read.

On one side it says: “Why the Market Will Keep Going Up” and on the other it says: “Why the Market is Going Nowhere”. Technically those two statements aren’t polar opposites. Had the negative one said “Why the Market Will Crash (Again)”, that would have been a truly contradictory statement. But then again, the stairs are leading down so maybe I’m over analyzing this. So, will the market go up or down? Yes.

The Evolution of Overconfidence
Finally, here is a fascinating article from MIT’s Technology Review about the evolutionary underpinnings behind the human propensity for overconfidence. Since it is an inherently a self-destructive behavior, how did we manage to survive and why is it part of us in the first place?

By creating a mathematical model of the way overconfident individuals compete against ordinary individuals, they show that there is a clear advantage in overconfidence.

In fact, if the potential reward is at least twice as great as the cost of competing, then overconfidence is the best strategy. In fact, overconfidence is actually advantageous on average, because it boosts ambition, resolve, morale, and persistence. In other words, overconfidence is the best way to maximize benefits over costs when risks are uncertain.

While that may be a neat and tidy explanation, the corollary is disturbing:

Their model implies that optimal overconfidence increases with the magnitude of uncertainty. So the greater the risk, the more overconfident individuals should become. Johnson and Fowler use that finding to predict that overconfidence will be particularly prevalent in domains where the perceived value of a prize sufficiently exceeds the expected costs of competing.

Sound familiar?

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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′