Trader’s Narrative

Forget gold and gold stocks. It is time for silver to shine in the precious metals’ sector.

At least that’s what the Commitment of Trader’s report is telling us.

Lately the commercials have been been net short the least number of contracts in five years. Since they are almost alwas net short as part of their usual business, what matters is whether they are really, really short or just a little bit.

Right now the most knowledgeable players in the silver market want to limit their exposure to a potential rise in the price of silver.

The last time they had this nominal contracts net short was in the summer of 2003 when silver was less than half of what it is now. Even more meaningful, the small speculator isn’t excited at all. Eventhough the price of silver has shot through the roof, they are holding their smallest net long position in years.

In contrast, we are seeing the exact opposite in gold’s Commitment of Trader’s report.

Here’s a quick snapshot of this week’s sentiment landscape:

Investor’s Intelligence
Of the usual sentiment surveys this one is showing the most froth at almost 54% bullishness. The II bears have been quickly reduced to less than 30%. This is a very quick and very sharp about face.

Put-Call Ratio
Not the usual sentiment indicator but a worthy market barometer: the CBOE equity only put call ratio is at 0.53 and that’s just too high. The option market is too euphoric for the rally to continue much longer. As I already mentioned yesterday, it is time to sell something into this strength (if you have a short term time horizon). The time to scoop up shares was when the put call ratio was above one.

From Barron’s
Last weekend’s Barron’s had this tell regarding sentiment in the blocked fixed income market:

More than one quarter of the news-articles citations of “ABCP,” for asset-backed commercial paper, since 1993 have occurred in the past six weeks, according to the Factiva Database.

Usually when everyone and their cousin is talking about something, it has played itself out and the opportunity or trend is over.

Hulbert Stock Newsletter Sentiment
The Hulbert Stock Newsletter Sentiment Index, as of the close of trading on Tuesday September 18th, stood at just 17.4%. That’s a puny 3% point increase for a day which gave us the breathtaking 330+ point rally in the Dow Jones Industrial. Even more telling, the most recent HSNSI reading is much lower than in mid-July, when the stock market was much higher and close to 14,000. During that attempt, the HSNSI got as high as 50.9 %.

Commitment of Traders
I’ve described the ginormously long commercials position again and again. This week brings yet another increase in their long position as they continue to increase their bets of a continued market rally. I find this either the most bullish sign out there or the most elaborate mirage. The intensity and single-mindedness of this tell is alarming. If this is a mirage, what other explanations can there be? What am I missing?

“Bin Laden” Trades
So what happened to all those breathless conspiracy articles about a doomsday trade of gigantic proportions? a multi-million dollar derivative bet that the market was going to crash? As the market rallied, the silence is deafening. What a perfect illustration of contrarian sentiment and how by zagging when others zig, one stands to make money.

The two major groups in the stock market have been and will always continue to be large, well capitalized and well informed “insiders”; and the small, underfunded, emotional, ignorant retail investors and traders.

These two groups engage in a financial dance which invariably concludes in the long term with one group enriching the second. Although they usually don’t take such contrasting positions, at times they can mirror each other.

A good example was in 2000 at the top of the internet bubble. The knowledgeable, “insider” team made up of hedge funds, investment banks, other Wall St. operators and the private equity team sold bits of paper (shares) in exchange for money from the retail crowd.

Right now we are seeing another one of those times. But this time it is the “insider” team that is on a buying spree.

Commitment of Traders
I’ve already mentioned that the commercials were crazy long equity futures contracts and although some time has passed things have not changed. The commercials are long about $38 billion worth of contracts while the small speculators are long their smallest amount since the bottom of the bear market.

Fund flows
According to fund flows data estimates, as the retail investor is fleeing the equity markets and seeking the sanctuary of bond markets and money market funds, the institutional investor is buying with the same intensity. Watch video about half way on the link.

Insider Activity
Corporate executives and other insiders are probably the most knowledgeable about a company’s future and while the market has taken a tumble, they haven’t been spooked. On the contrary, their buying here is only equaled to that seen at the bottom of the bear market. This in contrast to the retail investor who has been buying anything but US equities.

Newsletter Market Timers
The best market timers among the newsletters are wildly bullish, with an equity allocation of 92%. Meanwhile the worst are out of the market completely with a 0% allocation.
Credit: Mark Hulbert in Barron’s

Well, that was something. Wasn’t it?

Simply breathtaking.

I love it when things align like that. I had to take care of some things yesterday or you would have found me gloating about this much earlier

An old saying around Wall Street is that the market moves to exert maximum pain to the maximum number of participants. If this isn’t what just happened, I don’t know what is. Who in their right mind could have foreseen what happened this week? the breakout? the sheer intensity and unrelenting buying pressure?

Unfortunately for them, those that bear the brunt of the damage tend to be the outsiders, the unwashed masses, otherwise known as retail investors and traders. For the most part, insiders make out just fine.

Speaking of insiders, the latest Commitment of Traders report, hot off the presses, shows a continuation of the same lopsided buying from the commercials. Brace yourself, because since the last report, commercials have increased their aggregate net long position by 36%.

Eventhough I was bullish as I outlined this past week, I was still taken aback by the force of the bulls. They simply demolished the bears. I don’t care what thesis a bear trots out: inflation, the dollar, China, etc… it is all meaningless in the face of such a clear and powerful breakout.

What’s more fascinating is that according to the Hulbert sentiment measures, newsletter publishers are not at all excited about the market… even as it has gone up. In fact, in the face of a rising market, sentiment has actually become less bullish. To be specific, in late February 2007, when the market was going strong (before the correction), bullish sentiment as measured by Hulbert, was 62.4%. Since then, the market has recovered the correction and then some. But newsletter bullish sentiment is now 40.6%

And Thursday’s rocket ride did not make one iota of difference! It seems like the newsletter writers out there are scoffing at the price action as merely a mirage. Who knows, it may very well be. But with history as a guide, we know that the probability of it being real is high when there isn’t much excitement accompanying market gains.

But (there’s always a but) the Investor’s Intelligence report on newletter sentiment shows a completely different picture. According to II there are 21.3% bears and 49.5% bulls. That is a fairly toxic ratio of bulls to bears. But if we look back to 2003 we see that after the bear market low was made, and as the market rallied almost continuously for the whole year, the sentiment was equally bearish according to II. So maybe history will repeat. But why are the sentiment measures so at odds?

I believe it is because Michael Burke and his team over at II use a different method to categorize newsletters. Rather than going by what the newsletters are recommending (which Hulbert does), they go by their feel of the bullishness or bearishness (or neutralness) of the newsletter after a reading. This is a much more subjective method and may account for the variance between the two sentiment measures. Ideally, we would like to see them agree with each other. But we can’t have everything now, can we?

In early June I stumbled on a promising indicator for finding market tops. As a student of the markets I’ve desperately searched for a reliable tell for tops. But for the most part the prey is elusive.

Market bottoms are much, much easier to find than tops. The VIX index pops, the put call ratio spikes, sentiment goes haywire, and on and on. There are literally dozens and dozens of indicators that one can line up as good signs of a market bottom.

The indicator that I mentioned involves the interplay between the stock market and the bond market. As the rates in the bond market rise, the stock market usually suffers because money starts to flow out of equities and into less riskier (and higher yielding) bonds. And vice versa.

It is simply, the 30 day rate of change of the 10 year Treasury Bond yield. When it approaches 9% (or more), the stock market tends to get weak. Especially when immediately prior to the signal it has been on an uptrend.

This is what we had in early June 2007 and so far, the signal has been good. I suppose we could argue whether the June high water mark is truly a “top” or whether it is simply a pause. To really know, we need more time. Still, one can’t argue that entering at that time wasn’t a good idea since it wouldn’t have made you any money. In fact, exiting to preserve capital seems to have been rather smart.

Of the major market proxies, the Nasdaq composite is the only one that has surpassed its early June highs. The Russell 2000 Small Cap index, the Dow Jones, and the S&P 500 have all traded within a range.

But I’m still rather bullish for the intermediate to long term time frame. I’ve shared with you a few reasons for that. Most recently, the remarkable Commitment of Traders report, the short interest ratio and finally the total apathy from retail investors. The fly in the ointment continues to be the flacid financials.