Trader’s Narrative

Here’s this week’s sentiment overview:

Sentiment Surveys
Let’s start with the most common sentiment measures:

The AAII came in this week at 27% bullish and 46% bearish - little changed from last week (one percentage point variation, if you are that curious).

ChartCrafts’ Investor’s Intelligence results this week shows a bit more movement with the bulls and bears returning to approximate parity: bulls at 38.7% and bears at 36.7%

ISEE Sentiment
Amazingly enough, during this catastrophic bear market, the retail option trader, as measured by the ISEE Sentiment index has been completely unfazed. The index is a ratio of call to put option purchases (to open a position) and therefore, a low number denotes fear. Looking at the equities only chart of the ISEE from 2008 to now there is remarkably little concern as the index has only fallen below parity a handful of times:

CBOE Put Call Ratio
The traditional option sentiment index is mirroring what the ISE sentiment index is telling us. As you can see from the charts below, the last time puts were more popular than calls, we had a significant rally, which put in the low (for now). However, as the market continued to recover into the new year, it was puzzling to see fear also increase. And now as the market has weakened and approached the November 2008 levels, option traders are not concerned in the least:

Again, this is similar to last week’s sentiment overview where we saw evidence of too much optimism. All in all this tends to paint a fairly clear picture of the prevalent sentiment out there but not one that many longs will be happy to see.

UPDATE:
Economist Magazine Cover
Don’t know how I missed this since I was actually reading the magazine! Here is this week’s cover:

After yesterday’s decimation of the indices, today’s sharp bounce was not that surprising. We had almost the mirror opposite: +90% of volume flowed into advancing stocks on the NYSE and 85% on the Nasdaq.

Advancing issues far out numbered the decliners also but not as much as the opposite yesterday. The percentage and points gained were similar in that the market clawed back some lost territory, but not nearly all that it lost on Monday. So I’m not sure if today’s brave snap back rally qualifies fully as a Lowry’s 90-90 up day.

Option Traders On Valium
The state of the options market continues to befuddle me to no end. The retail options ratio compiled into the ISEE sentiment was an eyebrow raising 112 yesterday - which means that retail option traders opened more trades with call purchases than with put purchases. On a day when the Nasdaq lost 9%. On a day which was referred to by blaring newspaper headlines as “BLACK MONDAY”. On a day where we had 98% downward pressure in equity volume.

And today, it came in much, much higher. OK, I’d expect it to do what it did today, but yesterday’s action just doesn’t make sense. Unless the ISE is on the fritz and made an error.

Similarly, the put call ratio from Chicago came in at 0.79 and 0.73, yesterday and today, respectively. Ho-hum. If you had just been given these figures you would never suspect that we had just gone through a stomach churning roller coaster ride. Would you?

Go figure that out and then come back and explain it to me (no really, please do).

TED Spread
What is another day if we don’t set another record. The TED spread pushed above recent high which itself was in multi-year record territory and closed at 3.5 points. For an explanation of this important fixed income indicator, see the link.

Dejavu, All Over Again
Here is a long term chart of the bullish percent for the S&P 500 Index (SPX):

Sure, we are back down where we’ve seen the market rally, but do you notice anything about the chart?

While the bullish percent has been hitting extreme lows, it hasn’t subsequently recovered to extreme highs. All it has managed to do is push back to the neutral zone. It hasn’t once in 2007 and 2008 (so far) reached +80-85% as it did during the bull market.

September…
It only seems fitting on the last day of September to revisit the historical pattern that I brought up at the beginning of the month: Why you should write off September

No argument that it would have been much more profitable to have sold every long position at the start of the month and taken a long nap. As Tim suggested back then, you can always short… except when the government doesn’t let you

Don’t Spill Your Drink
I’m not seeing as much negative sentiment out there as I’d like. Take for example, the Hulbert measure of newsletter editors which is showing that market timing stock newsletters are absolutely sanguine about Monday’s drop. And they are more bullish now than during the spike low in July… even though the market is trading lower than back then.

My own anecdotal evidence comes from a cocktail party over the weekend where no one was at all concerned about the stock market, although most were familiar about the crisis and its effect on the financial markets. If anything, there were guests which argued that this was a great buying opportunity. Now, I know this is just anecdotal but when I look at the options market action (ISEE sentiment) I see parallels. And if that doesn’t concern you… it should.

Dazed & Confused
So I continue to be amazed at the action and watch cautiously, careful to not step into a sinking floor. We are seeing some good technical and market internal metrics build concensus towards a tradeable bottom. But I don’t believe we are there just yet.

As a caveat, you should know that I was premature in jumping aboard back in March when I saw indications which persuaded me that was an intermediate stock market bottom in the making. So perhaps now I’m playing it too safe?

Perhaps. Instead of second guessing myself though I prefer to stick to the most quantifiable measures and technical analysis, thereby removing as much “hunches” or “intuitions” as possible. I suspect that we will see today’s cosmetic recovery fade away and a cascade lower will bring much needed panic.

During the cyclical bull market that started in early 2003, every time the market penetrated its long term moving average, it ricocheted off like a smooth pebble off a lake.

In hindsight, it looks quite orderly and beautiful (see chart). But each time the indices breach their 200 day moving average, it alarms a lot of investors and “experts” who start to pontificate about the importance of this simple technical indicator.

There’s nothing magical about it. In a bull market this behavior is normal. But in a bear market, the opposite is true - that is, the market is hardly given the chance to poke its head above the 200 day moving average and when it falls below it, it goes deep. In the summer of 2002, for example, it went more than 25% below.

The noticeable change is that since the intermediate bottom in August 2007, each subsequent trip below the 200 day moving average has been lower. After today’s shellacking we’re now -5.5% - a place we haven’t been in more than 4 years.

So is this it? Are we on the cusp of a new [gasp] bear market?

No one knows.

All I can do is to follow the technical and sentiment signposts that have been helpful in the past and try to use them to make some sense out of it all.

Although they never line up perfectly, most of the indicators I see are pointing to a correction. The most convincing argument is that investors and traders are reacting with complacency but fear.

I’ve already outlined the sentiment overview, and to that we can add today’s CBOE equity put/call ratio which reached 0.97 - a level that it reached before in mid November 2007, mid August 2007 and March 2007.

Arguably, the biggest chink in the armour for bulls is the lack of extreme bearishness in sentiment that would give way to an outright capitulation by sellers. When I listed the 12 Reasons Why This Is A Buying Opportunity two days ago, sentiment survey results hadn’t really come in yet.

They’re now in and we can take a look at how market participants reacted to the decline. (I already covered LowRisk, so I’ll skip to the others.)

Investor’s Intelligence
The recent II results show 47.2% newsletters as bullish, down 6.7% points, and 26.4% newsletters bearish, up +8.4% points. That’s the direction that I’d like to see sentiment heading in. But the degree to which newsletters gave up their bullishness is still not enough to cause a wide enough swing to take us to a contrarian bullish level. While just before the market tumble, it was way too bullish, II is now, at best, mired in neutral territory. So it isn’t much of a help. Except to show that we still don’t have capitulation.

AAII
The AAII survey is equally lukewarm. Bears increased by 3% points to 40% and bulls increased by 2% points to 46%. The bull ratio hardly budged. Not at all the sort of sentiment reaction I was expecting. Especially with the plethora of negative headlines and news reports about the market and its scapegoat, the subprime mortgage market.

ISE Sentiment
In early March 2007, we got a cluster of 3 back to back readings in the 60’s. Meaning that approximately 60 some odd calls were purchases for every put on the ISE. Right now, we’ve only dipped to 78. And today, eventhough the market closed very weak, the ISE Sentiment Index jumped 25 points to 103 - so as the market went down, ISE traders purchased more calls. That’s not capitulation. That’s stubborn bullishness. And frankly, it punches holes into the bullish case.

Put Call Ratio
Similar to the ISE Sentiment index, the put call ratio oddly shows a dangerous amount of complacency. Even as the market sliced through its support area this afternoon, I can find no real rush to buy puts. It seems that traders are comfortable with the declines. And if there’s anything that should send shivers down the backs of bulls, it is that.

I’m actually a bit confused about this because the last time I checked in on the put call indicator, it was showing an extreme spike. But now, it seems that it was an error, either from the exchange or the datafeed provider. In any case, eventhough the put call ratio is in the “green” zone, it still hasn’t shown the kind of whoosh I’d like to see (the kind that gives investors reason to change their pants).

Conclusion
One, I better start double checking my data! Two, we do not have capitulation from these sentiment indicators. As long as they show a comfortable and complacent market, the probability of a continuing decline increases.