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.

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 this week’s summary of stock market sentiment happenings:

Sentiment Surveys
Even as the stock market bounced higher, the US retail investors, as measured by the AAII weekly sentiment survey, grew slightly more cautious. This week’s survey showed an increase of bears by 6% points to 44% and a small decrease in bulls to 37%. This is an intriguing turn of events, especially considering that just a short while ago, more than half of this same group of investors was extremely bullish. But just a small pothole on the way to higher stock prices has spooked them to not only grow less bullish very quickly but to also remain so. But there is anecdotal evidence that they are tip-toeing back into the stock market.

In contrast, newsletter editors as measured by ChartCraft’s Investors Intelligence sentiment index continues to be wildly bullish with optimists outnumbering pessimists 2 to 1. This week the bulls diminished slightly to 23.6% and the bulls also shrank a little bit to 48.2%.

And finally, the Hulbert Stock Newsletter Sentiment index shows that the small subset of market timing newsletter editors tracked by the Hulbert Digest have not materially changed their posture. But the Hulbert Nasdaq Newsletter Sentiment index has registered a serious decrease in optimism. This sentiment measure was 57.1% on August 21st, 2009 when the Nasdaq was at 2020. Meanwhile, today the Nasdaq closed almost 61 points higher, but the HNNSI is just 28.6% - almost exactly halved.

We’ve been witness to a schizophrenic sentiment outlook recently. This choppy, one day bullish, the next day bearish, and then back again type of action is usually characteristic of corrections. Such lack of conviction, with everyone ready to switch camps at the drop of a hat makes me think that one side will eventually be caught on the ‘wrong’ side of the market. And their pain will fuel the next leg, either up or down. Honestly, right now I’m not convinced myself which is more likely. I’ll prefer to be in the audience until the fog lifts.

September’s Seasonality
True to form, with everyone’s attention directed towards the dire September seasonality, the market has staged a rocket-ride higher!

Consumer Confidence
The Reuters/Michigan University consumer confidence data released today rose above 70 again. The last time it was in the vicinity of this area was a few months ago in June.

Both the current conditions index and the expectations index rose from August. Either the average US consumer is simply believing the stock market’s message or the US economy is actually getting better.

The consumer confidence survey from Gallup also shows a similar increase (see chart on the left). In fact, the current level is the highest consumer confidence level since they started to track this question at the start of 2008.

Option Traders
Thursday’s one day ISE sentiment (equity only) index was 210 - meaning that there were 210 equity calls purchased by retail clients for every 100 puts. That’s the highest level since July 28th, 2009 when the S&P 500 was at 980 - some 70 points lower. But that’s just a one day super-bullish event so it has little consequence, especially as the ISE index fell hard on Friday (to 137). The short term (10 day) moving average is much more meaningful and it is at 171 which leaves it mired in neutral historical territory.

The CBOE put call ratio (equity only) continues to register very strong bullish sentiment:

The short term moving average is still at a very low level and it is also well under the multi-year channel line. It is certainly possible that this ratio can continue to be mired in this area for some time. The CBOE put call ratio is eve more bullish that it was at the beginning of 2007.

Lighting the Afterburners
This week we saw an incredibly powerful thrust in the markets with pretty much every single issue out there moving up. While this following data point is not technically a sentiment measure, it is definitely a consequence of the return of risk taking on Wall Street: this week saw more than 3 out of every 4 NYSE issue trade higher. This is, needless to say, a rare moment in market history. On the flip side, you’ll recall that earlier in the week Wayne pointed out the incidence of zero new lows in the NYSE.

Here is this weeks summary of sentiment data for the stock market:

The weekly AAII measure of sentiment continues to reflect a repentant US retail investor. This week the bulls were unchanged at 34% while the bears increased 9% points to 49%. This is a very abrupt change as it was just 4 weeks ago (Sentiment Overview: Week Of July 31st, 2009) that we had the mirror opposite with 48% bulls and 31% bears. And it was only 2 weeks ago when we saw 51% bulls! This is especially meaningful as the market is actually trading higher

Meanwhile, the Investors Intelligence Advisors Index - a metric of the mood of stock market newsletter editors - is finally showing extreme levels of bullishness. This week’s results pushed the bulls slightly upwards to 51.5% while at the same time reducing the bears to just 19.8%. That widened the gap between the two camps to almost 32% points or put another way, we now have almost 3 optimistic editors for every gloomy one.

So it took the II a few weeks to arrive at the +50% levels of bullishness that we saw from the AAII earlier this month. But while the AAII’s recent lopsided sentiment corresponded to the swing top in May 2008, the discrepancy in the II is even more ominous.

The last time we had less than 20% of the stock market advisors bearish was in October 2007 - the start of the bear market. While the percentage points between the two camps isn’t as wide as in October 2007 (40% points), it is 31.7% points - close enough to merit caution for the bulls.

Right now, looking at these two popular sentiment metrics can be confusing. Either one is ahead of the other or they are both wrong. Fortunately there are many other indicators we will take a look at after the jump.
Continue reading ‘Sentiment Overview: Week Of August 28th, 2009′

Here is this week’s sentiment round-up:

The AAII weekly sentiment survey shows that the consensus reversed suddenly from the giddily bullish extreme that we saw last week. The bulls fell to 37%, a decline of 17% points. And the bears increased to 40% coming to an almost perfect equilibrium.

While this is a dramatic decrease in their level of optimism, I’m still cautious. The last time we had the same level of bullishness in the AAII survey was in early May 2008. And as I mentioned during last week’s sentiment overview, the stock market didn’t roll over immediately in response. The S&P 500 actually climbed slightly higher in the following weeks. So just because the market has overtaken last week’s highs does not absolve it from a potentially mortal weakness.

The average exposure recommended by stock newsletter editors (as measured by the Hulbert Stock Newsletter Sentiment Index) fell to 30.3% - that’s a sharp decline of 17% points from just 7 days ago. From a contrarian point of view, if the level of bearishness continues to rise even as the stock market rises, then it would imply that this rally still has some life left in it. But we aren’t there yet.

This week’s Investors Intelligence survey was little changed from last week: the bulls were at 48.3% and the bears at 23.1%. This is the only sentiment survey that is dancing to its own tune.

According to the AAII asset allocation survey equity allocation has reached 57% - a level last seen before the equity markets started their cascade down last year.

We touched briefly on the bond allocation at the beginning of the month. At 25% (a 9% point jump!) it is not only the single largest increase but also brings bonds to the highest chunk of the AAII portfolio it has ever been since 1987 when they started keeping track.

Finally, to round off, retail investors are finally feeling comfortable enough to leave the safety of cash. After the cash portion of their model portfolio reached a peak of 45% earlier this year, it is now down to just 25%. As I’ve mentioned before, there is a massive pile of cash sitting on the sidelines and it is slowly being deployed. Of course not all of it is ending up in the equity market, but considering the size of the build-up, even a small portion can have a significant effect.

The NDR Crowd Sentiment Poll is a proprietary sentiment measure from Ned Davis Research. It surpassed its extreme level (61.5) last week. Since then however it has backed off from this threshold and is now 4.3 points lower to 59.1 - this is similar to the other sentiment surveys covered above.

Fund Manager Survey
According to a Merrill Lynch survey of 204 fund managers, managing a total of $554 billion, 75% believe that the global economy will improve in the next 12 months. That is the highest level of optimism since November 2003. A smaller amount (70%) expect corporate profits to rise in the coming year.

Fund managers are putting money where their mouth. They have reduced their cash levels from an average of 4.7% in July to 3.5% in August - the lowest level since July 2007. They have also increased their allocation to equities sharply from last month. Merrill Lynch’s Risk and Liquidity Indicator, which measures risk appetites is at a 2 year high.

This dovetails nicely with what we are seeing from the AAII model portfolio allocation (above). The build up of cash was a sudden, fear induced spike. But the unwinding of it is more orderly as a gradual stream of investors decide that it is safe to venture out once more and take risks again.

Option Traders
The CBOE (equity only) put call ratio continues to fall as optimistic traders prefer calls to puts. Friday it closed at 0.51 meaning that traders were trading twice as many calls as puts. The simple 20 day average of this ratio is now at 0.587 - the lowest since June 2007:

Perhaps more importantly, the short term moving average has as a result, broken well below the multi-year rising channel that contained the put call ratio (red arrow).

The lesser known ISE sentiment index (equity only) reached a high of 202 on Friday. Being a call put ratio, this means that for every 100 puts, there were 202 calls being bought. But the short term moving average of this indicator is still treading water and not at an extreme.

Magazine Cover Indicator
Here is the August cover for Futures - a magazine dedicated to news and analysis of options, futures and stock trading. It is not a general interest magazine like Newsweek or even Business Week so I’m not sure how much contrarian weight we can put on it.

In any case, the image is of a hazy outline of a bull appearing in the distance. The implied question is, “It might be, it could be, is it?” meaning a bull market. Obviously this is the question that many are grappling with.

The interesting aspect of this cover is that it is not boldly trumpeting the arrival of a new bull market but instead timidly asking if it might be, could be true. And finally, wondering if it truly is.

By the way, if you have a US mailing address, for a limited time you can get a free subscription to Futures Magazine. I’m not sure how long this special offer will last so sign up right now.

Consumer Confidence
The preliminary Consumer Confidence survey from Reuters/University of Michigan showed a surprising decline to 63.2 for August - back to a level not seen since March 2009 when the market hit its trough. It would seem that the US consumer is being buffeted with the cross winds of deflation, which make things more affordable, rising unemployment and a schizophrenic stock market. No wonder then that they can’t seem to make up their mind: