Trader’s Narrative

Below is this past week’s summary of sentiment data:

AAII
According to the American Association of Individual Investors, the average retail investor in the US is down right giddy. This week the bears declined by 2% points to number just 33%. The bulls meanwhile managed to eke out a tiny 1% point increase from last week to reach 51%. Anytime we see the magical 50% mark in either camp, I take special notice.

To find a higher level of bullishness, we have to go back to May 2008. For the week of early May 2008, the AAII survey showed 53% bullishness. In that sentiment overview, I wrote:

There is no way we can discount or ignore this. Such a high level of bullishness is downright frightening - from a contrarian point of view.

When I wrote the above, the S&P 500 was trading around 1410. In a few weeks it had managed to peek over 1420. But that was it. If you were looking or a sign that the market rally had petered out, you would have a hard time finding a better one. By July 2008 it had fallen to 1200 and by November to 750. As well, this level of bullishness is extra noteworthy because it was at this level of optimism on October 2007 that the stock market topped and entered into its current bear market.

In the same way, I think today, if this single data point doesn’t make you run for the door, it should at least be making you eye the exits warily. While the retail investor has been building back their confidence throughout this rally, their increasing bullishness will inevitably reach a climax point. Here’s a chart showing the last 3 times that the AAII sentiment was so optimistically lopsided that at least 50% were bullish:

Continue reading ‘Sentiment Overview: Week Of August 14th, 2009′

There’s a lot to cover in this week’s sentiment overview, so let’s get started:

Investors Intelligence
This week’s ChartCraft’s survey of stock newsletter writers delivered only 29.7% bulls - up slightly from last week. And almost unchanged from last week, 44% bears.

Market Vane
Market Vane dropped again to the low 30’s - a level last seen in October to November 2008 when the market made a short term spike down. That’s relatively low but not on an absolute level since it fell to sub-20 readings in the last bear market bottom between 2002-2003. To read more about Market Vane and its origins, check out A Brief History of Contrarian Analysis.

AAII
But the most fascinating and historic reading comes to us from the AAII weekly survey. The latest American Association of Individual Investors (AAII) data shows what can only be describe as total and utter capitulation. As of Wednesday (March 4th, 2009) 70% expected the market to continue to fall, while only 19% continue to see better times ahead.

The only data point from the AAII survey that approaches this level of gloom is back in October 19th, 1990 when a paltry 13% of respondents were bullish and 67% were bearish.

Source: SentimenTrader.com

ISE Sentiment
In contrast, the ISE put call ratio (also known as the ISE Sentiment index) continues to tread water, seemingly oblivious to any risk. The only data that can be interpreted as slightly bullish is that for the second time this year, it fell below parity - barely. On Wednesday March 4th, 2009 the ISE Sentiment fell to 95. The only other time it fell below 100 was back in February 3rd 2009 when it hit 97. Since January 1st 2008, it has only fallen below the parity level ten times.

CBOE Put Call Ratio
Similar to the ISE data, the CBOE put call ratio shows no sign of flight to safety. On March 5th it reached 0.90 - a relative high but by no means a level which shows a serious sense of risk.

Corporate Insiders
Once again corporate insiders stepped up to the plate to buy their companies’ shares. Although there is a noticeable spike in purchases (relative to sales), I wonder if it means anything because it is another in a series of similar spikes that we’ve seen going back to November, July and March 2008.

TED Spread
This indicator has fallen off everyone’s radar - and for good reason. Right now the TED spread is still high at around 1.0 but it is far from the peak of 5.0 reached at the zenith of last year’s credit crisis. Still, relative to its own long term average it is still very high since it averaged around 0.4 for the past few years.

Hulbert Sentiment Index
The bad news is that at the start of the week, the Hulbert Stock Newsletter Sentiment Index (HSNSI) is at -20%. Meaning that on average, the newsletters that time the market are advising clients to short the market with 20% of their portfolio. Although this is a low number, HSNSI was more than twice as low last July. So while the market has continued to fall, stock timing newsletters are half as pessimistic.

Compared this to the previous significant market bottom in March 2003. On March 10th, the HSNSI was -19.2%, almost equal to where it stands now. But back in July and October 2002, the HSNSI was -15% and +20% respectively. So clearly, we aren’t seeing full blown capitulation from market timing newsletters.

Magazine Cover
Business Week is one of my favorite magazine indicators because it has such a rich contrarian history. This week’s cover isn’t as pessimistic visually as the corresponding article.

Inside, the cover article goes over the failure of the usual indicators, whether sentiment, technical, monetary, etc. to be act as guides in this past bear market. It quotes experts ranging from James Stack of InvesTech, the Leuthold Group, and TrimTabs’ Biderman who each metaphorically throw up their hands in frustration. The gloomy outlook is punctured by a few positives but the conclusion is:

A more probable outcome is the one drawn from the narrow history of bear markets that grew out of financial crises. In it, the bear scenario continues to play out until the bull takes over, with more debt busts and government trial and error until things get set right again. That could mean two more years of bouncing around and then another six or so before the Dow is back above 14,000. Not long ago, such an outcome would have seemed unimaginably bleak. Given the other possibilities, it doesn’t seem so bad now.

Source: When will the the bull return?

As the market races to the bottom, corporate insiders are racing right along buying with both hands. For the past four weeks, insider activity as monitored by InsiderScore, corporate executives and board members have been in what can only be described as a buying frenzy.

According to InsiderScore, “insiders are more bullish now than at any time since the two weeks immediately following the Black Monday market crash of October 1987“:

Source: InsiderScore.com and SentimenTrader.com

I checked with a similar service that tracks Canadian stocks: Canadian Insider and not surprisingly, the Canadian market is showing a similar pattern of insider buying.

The pattern was especially noticeable for Canadian REITs. And I’m not referring to ESOP where there is a preset schedule. REIT insiders are going out into the market and buying of their own volition. RioCan REIT, which I mentioned a few days ago, had 11,440 units purchased just on November 19th and November 20th, as an example.

The same can’t be said about precious metal stocks. For example, Barrick (ABX) and NovaGold (NG) do not show any buying interest from corporate insiders. If anything, there is a slight bias of selling. Which means that while insiders as a group are very bullish, they are still being selective. The k-ratio fell to 0.23 and has rebounded with Friday’s move in gold. That’s getting close to an attractive level for gold stocks, but if we are headed for a deflationary spiral, gold doesn’t stand a chance. But so far, the Philadelphia Gold Bugs Index (HUI) has bounced off the 175 level which I mentioned would act as support.

There’s Always a But…
A caveat to consider: in September 2007 insiders were enthusiastic buyers. Although not nearly as now. That uptick in buying was, of course, not very profitable since most stocks topped out shortly afterward. The question now is, does today’s frenzy mean that insiders see real value or will we simply see the market fall more and insiders get even more excited about buying?

Whatever the answer to that, the solace that the current buying pattern does provide is that insiders are not selling. The worst possible scenario after all, would be to see the “smart money” insiders bail out after the market’s face melting 50%+ decline.

Here are some thoughts with my own conclusions at the end:

Ned Davis Research
A very respected institutional research house, Ned Davis’ company relies on 12 indicators covering sentiment, volume, volatility, and breadth. Right now ten are flashing a cyclical buy signal. But a unanimous result isn’t needed for it to be valid. For example, in the bear market bottom of 2002, only nine of Ned Davis Research’s indicators was indicating a buy. But they are not recommending to their institutional clients to start buying. They want to be patient and wait for a retest of the lows. If market internals are healthy on such a retest, then they would suggest going long.

Stock Market Cycle
There are patterns in the market’s history. But so far this year, the market has forged its own path. An election year should be a positive for market returns, especially in the later months of the year. But not this year.

The four year stock market cycle means that 2010 is the year to watch. But according to the decennial cycle, the 8th year in a decade has been good historically. Unless we have a miracle, this year will also be an exception. Here is the master of market cycles, Peter Eliades offering his views:

Credit Squeeze Relaxing
Both the TED spread and the LIBOR rate have receded. As well the price of “insurance” on default for banks has also dropped. There are mounting signs that we are seeing a thaw in the credit freeze that paralyzed the market. My only quibble is the short term rate (90 T-Bill rate) which continues to be pushed down. The bond market is telling the Fed to lower rates. Hopefully they will listen (unlike all the previous times) and get ahead of the situation rather than playing catch up.

Volatilitius Maximus
Volatility has been absolutely insane. There is no gentler way to put it. We’re seeing double digit (or close) moves in the market daily. It is both unnerving and exciting. And here I’m not just referring to the sky high VIX index but also to the breadth numbers which show extremes. The good news may be that such volatility has been historically associated with market bottoms. As I wrote two years ago, extremes in market breadth with the advance decline numbers swinging from one extreme to the other to gather “fuel” for a sustainable trend to be established:

Smart Money vs. Dumb Money
At every inflection point in the market, we witness the smart money and the dumb money do different things. This is how wealth is transferred from one group to the other after all. So far we’ve seen Warren Buffett extract very favorable terms with General Electric (GE) and Goldman Sachs (GS). Terms that the US government hasn’t gotten. That’s another issue though. Although you or I may not be able to negotiate the same terms, it is still valuable to watch what the smart money is doing.

Which reminds me of Tony Oz’s video where he called a bottom. Faced with a melt-up, he did what any smart trader would do, sell into the wave of buying.

Corporate insiders are also considered “smart money” and they have accelerated the rate of their purchases, pushing the buy-sell ratio to 2:1. This is very unusual because usually it is the other way around as insiders sell shares which are given to them as part of their compensation package. But caution is warranted because insiders are notorious for being early to the party - as much as one whole year.

The other end of this see saw is to watch the “dumb money”. I’ve gone into detail over the past sentiment overview regarding the public’s and retail investor’s pessimism during this crisis so I won’t rehash it here. Now that we are getting the first glimpses of the bulls returning, the most important aspect of contrarian sentiment comes into play; watching how the “dumb money” reacts to a recovery in the markets. If they continue to be fearful and pessimistic, even when the market recovers, then the chance that it is a real floor is much higher. But if they quickly switch sides, then we will see more downside.

Conclusion
My own hunch based on all of the above and more, is that this is a cyclical bottom. It is tradeable, and the volatility provides amazing short term opportunities for trigger happy traders but we are far from a secular bottom. You’ll know we’ve hit that when stocks and the whole equity culture of the US and the world changes. When people start outright hating stocks or even the thought of investing.

When everyone laughs at you or feels sorry for you for even hinting that it may be time get back in the stock market. When the valuation pendulum swings way to the other side and measures, whether based on price earnings or price dividend are so outlandishly extreme that you do a double take. That’s when you’ll know we’ve hit a secular bottom. One for generations.

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.