Trader’s Narrative

Here’s the sentiment summary for this week’s trading:

Sentiment Surveys
According to the sentiment surveys, an alarming number of investors and market timers have returned to the long side. The weekly AAII retail investor sentiment survey shows 48% bulls (an increase of 8% points) and 37% bears (a decrease of 12% points). We haven’t seen this many bulls in the AAII survey since the first week of the year. As I’m sure you’ll recall, that was not a happy time for putting new money to work on the long side.

According to ChartCraft, the weekly Investors Intelligence newsletter sentiment survey shows 42.5% bulls and 25.3% bears. The S&P 500 ended the week 21 points higher (or 2.2%) so the market hasn’t really done anything to deserve such hope or devotion.

Barclays Capital Sentiment Survey
Barclays Capital said that only 17.5% of the 605 respondents to its quarterly sentiment survey believe that ‘risky assets’ have more room to rise. Those taking part in the survey were central banks, asset managers and hedge funds. The majority believe that the world economy will experience either a protracted slowdown or if it is in recovery now, it will falter once more (a “W” shaped recovery). Asked whether the spring rally was just a “bear market rally”, 60% agreed - indicating that there is still a lot of dry powder out there.

NAAIM
Along with most sentiment measures the NAAIM trend survey of managers has recovered since the spring lows. For more information on the metric check out: NAAIM Sentiment Survey.

Market Froth
We’ve seen a lightning fast return of speculative trading to the stock market. You can see it in the volume of ‘garbage’ stocks (trading below $5/share) and in the general willingness of most people to shrug off the dark foreboding sense they harbored just a few months ago that the end was nigh.

There is also mounting evidence from the Rydex fund flows that the trigger happy traders that use these securities to time the market are piling into the long side. This is the case for both leveraged and normal Rydex funds and has in the past marked either significant market tops or the start of a plateau. In either case, when there is so much lopsided optimism in Rydex mutual funds, it is a flashing red light for those long the market.

Magazine Cover
I have a gut feeling that this week’s Economist magazine cover should be framed somewhere for posterity. It is a graphic showing a Tyrannosaurus Rex made up of car parts, leaking oil (as if bleeding).

I can’t help but wonder, if by the time a magazine puts up something like this, have the auto industry sector reached a nadir?

And I’m not thinking that because the image is hyperbole but because it is a creative representation of the unvarnished truth. I’d prefer if it was on Newsweek or Time but we’ll see. I think this Economist cover is one we’ll come back to years from now.

What a week. This will go down in history so make sure you pause and take note. Wall Street just had its worst week in history. So how is the sentiment landscape?

Sentiment Surveys
As I hinted earlier in the week, we saw some downright gloomy sentiment from all the usual surveys. Investor’s Intelligence, which monitors newsletter writers sentiment came in at only 25.3% bullish and a whopping 53% bearish. This is the lowest number of bulls since 1994!

Of the AAII weekly sentiment respondents, 60.8% believe we are in for more downside while only 31.5% are bullish (the remaining few are ambivalent). This is the second highest level of bearishness from the AAII sentiment survey. The last time was on October 1990. For a graph see: AAII Sentiment.

Anecdotal
I’m hearing a lot of fear and loathing from all corners. Trader Mike’s blog is getting a lot of traffic coming in from people googling “how to short” which is always a sign of capitulation of some sort. Regular folks are disgusted with the market and fearful of their retirement security. You can see comedians and commentators on TV talking about the stock market every night. Steve Cohen, the legendary hedge fund virtuoso, apparently threw in the towel and told his whole trading floor: “You’re all idiots. We’re going to cash. I’ll see you in January.”

Rydex Market Timers
Before the rise of the ETF phenomena, the Rydex funds were the only vehicle which allowed market timers to jump in and out of the market, and to even take short positions (by buying a fund). Although ETFs have definitely eroded the popularity of Rydex compared to when it was the only game in town, they still have a very strong following.

Right now these market timers have skewed the asset ratio to a degree that we haven’t seen since the bottom of the bear market in 2002 and early 2003. Of the the total assets held in the Rydex S&P 500 Index funds, only 15% are long.

Hulbert Newsletter Sentiment
At the start of the week the Hulbert Stock Newsletter Sentiment Index (HSNSI) was -36.1%. Meaning that the average short term market timing stock newsletter was suggesting to their readers that they allocate that percentage of their portfolios as a short position. Going by absolute numbers, that is a very low reading.

But just a few months ago in July, the HSNSI was even lower at -42.9%, when the market was trading at a much higher price than now. To put both in perspective, in the aftermath of the September 11th terrorist attacks on the WTC, the HSNSI dropped to -13%. The lowest it got in the ensuing bear market was in July 2002 -15.14% and then a bit lower, -19.2% on March 10th, 2003.

Option Markets
I’m still puzzled by the way the options market has been acting because I expected it to show much more fear than it has. For example, the CBOE put call ratio (equity only) hasn’t even taken out the highs we saw in September (1.18), never mind those of March 2008 (1.35). The ISEE sentiment ratio also continues to show a total disregard for put options from retail traders. With the exception of Tuesday which saw it drop slightly below par, the ratio has shown that retail traders are actually opening more call than put positions!

Volatility
Are you sitting down? This week we saw implied volatility levels which eclipsed the 1987 Black Monday crash. The CBOE volatility index wasn’t trading or calculated back then, obviously. But it is “reconstituted” as if it were. The old method took volatility (VXO) to 86% (intraday high of 103%) . The new method (VIX) to 66% (high of 77%) and for the Nasdaq (VXN) 71.6& (intra day high 82.4%). It’s a good thing we are no longer using paper for charting or we would have to glue on a top piece to the right side edge of the graphing sheet.

Contra Hour Stand
The bulls made a brave stand at 3pm, otherwise known as “contra hour”. But in the end they failed to close above or even break even. Monday is round two. Lets see what the G7 meeting can accomplish.

Headline & Magazine Covers
You don’t have to look far to find incredibly bombastic headlines. Some would say they fit the times. Others that in hindsight they will be another sign of contrarian opinion. Here are two from the Economist magazine (a favourite of Sarah Palin, along with Pravda, the Witchita Gazette and everything else printed since and by Gutenberg):

Apologies for the delay, I’ve been trying to keep up with this fakakta market. Here is this past week’s sentiment overview:

Sentiment Surveys
The AAII survey for this week showed only 33.33% being optimistic (bulls), and again, a whopping 55% thinking that the market is going to continue to go down. If you recall, historically, anything above 50% bearish sentiment is very significant. However, sentiment in a bear market is different than that in a bull market. So adjust your lenses accordingly.

The sentiment survey of Investor’s Intelligence by ChartCraft showed only 33.7% bulls and 47.2% bears (with the rest sitting on the fence).

Before we leave surveyland, it is important to note that something has truly scared the average American investor because not only are they very pessimistic as described above, they are now positioning their portfolios so defensively, it has only happened a few rare times. They are holding a +35% in cash, only 51% equities and the rest in bonds. The last time we saw a lower equity allocation for these guys was way back in the throes of the last bear market (late 2002) where it reached into the 40’s.

Options Continue to Confuse
On Friday, as the market continued to bleed, the ISEE sentiment ratio came in at 119, meaning that retail option traders were comfortably buying more calls to open positions than puts!

And the CBOE put call ratio (equity only) came in at an anemic 0.79!

So the options markets continue to confuse the heck out of everyone. I’ve read as much as I could find about it but either people are scrambling valiantly to explain it with outlandish theories or they are outright ignoring it.

The best alternative theory I’ve heard put forward is from Barron’s:

I mentioned sentiment being fearful earlier and certainly the Chicago Board Options Exchange volatility index, aka the VIX, registered some extremely high readings this week. Dubbed the “fear index,” when the VIX reaches extreme highs it often marks a bottom of some kind.
Finally, something for the bull column.
But can we truly believe the VIX, which is based on options premiums? After all, investors are no longer allowed to sell more than 1000 stocks short thanks to a temporary ban. One of the few places to hedge a portfolio is in the options market, and that may be changing the VIX in ways we just cannot know at this point.
Anecdotally, I don’t see the “get me out at any price” fear in the mainstream and financial media. Investors are fearful, but I don’t think they are truly as panicked as we might believe.
So, the scales seem to be tipped for the bears, keeping capital preservation tops on my list of investment activities. The final word from Washington could change things in a hurry, but from the technical evidence we have, this bear market is not over.

The What Spread?
This is truly scary. The TED spread continues to go up. The what spread? Yeah, that’s what a lot of people are wondering too. Take a look at the chart showing the trend of this search query in google’s search engine (worldwide). At the beginning of September, things go bonkers:

The reason I say scary is that it is creeping higher rather than spiking higher. That makes it difficult to know whether the trend has exhausted itself.

Magazine Covers
A qualitative contrarian sentiment guide is the magazine cover. Ideally, it will be tremendously pessimistic and have wide, general public circulation. This week, the only one fits the bill is the Time magazine cover of the 1929 soup line with the title: “The New Hard Times”.

The Economist and Forbes are arguably specialty magazines but their most recent editions’ covers are pessimistic as well. Although, the Forbes one does show the chart going up towards the end. And the article that corresponds with the cover, also hits some optimistic notes, mentioning the large amount of cash on the sidelines (more details on the cash cushion here). So, as pessimistic covers go, it doesn’t really qualify fully.

There has been so much happening that an important sentiment indicator which I usually watch for slipped through the cracks and wasn’t mentioned in the sentiment overview for last week:

And BusinessWeek’s cover asks: Is It Safe Yet?
With the main article inside having a very bloodied bull staggering.

Here’s this week’s sentiment summary:

NASDAQ:NYSE Volume
I touched on the relative lack of volume and how this has historically marked tops, rather than spurred on rallies. Another troubling volume development is the ratio of volume on the Nasdaq compared to the NYSE. We are seeing a spike in this ratio, meaning that Nasdaq volume is significantly more than NYSE volume. Since the Nasdaq represents the riskier side of the market, this has usually meant that there is too much froth in the market.

Sentiment Surveys
Last week I pointed out the danger of having the AAII remain at 53% bullish when the market had gone down slightly. Although this week the AAII respondents were slightly less bullish (45%) it is good to see their excitement abate in the face of a week that saw the market go up.

This reversal however only slightly dilutes the contrarian bearish meaning of this indicator. We are still at a very high level of bullishness. Simply by receding from the extreme level of bullishness that we saw last week does not eliminate the topping signal that the AAII is giving us at this point. After all, it was in October 2007 when we last saw this sentiment measure at such heights.

Investor’s Intelligence, the measure of newsletter sentiment compiled by ChartCraft, showed little change going from 44.4% bullish to 46% bullish.

Hulbert Newsletter Sentiment Survey
In contrast to the sentiment surveys mentioned above, the Hulbert Stock Newsletter Sentiment Index is continuing to suggest that newsletter editor are still either skeptical of the market’s recovery or not really excited by it.

At the start of the week, the HSNSI was 16.2%, meaning that the average market timing newsletter was suggesting to their clients being long just 16.2% of their portfolio. This is much lower than the 27.5% which they were recommending in late April, even though at that time the market was lower than it is now.

Slicing and dicing the newsletters, Hulber finds that the stock market newsletters with the best track record of timing the market are continuing to be bullish, while those that have lagged buy and hold are much less so. This gap in sentiment and performance has, however, significantly diminished from mid-March - when the market hit its inflection point.

Is LowRisk Dead?
A reader already asked about the lack of updates from LowRisk. I emailed Jeff Walker, the keeper of the data and when or if I receive a reply I’ll write a follow up. The last update on their site is for March 23rd 2008. I haven’t received any email updates either - I’m subscribed. In any case, LowRisk was never one of the major sentiment surveys that I relied on. It was a bit too volatile and no one except Walker knew the size of the sample size.

Magazine Cover Indicator
Here’s an interesting magazine cover for analysis (below): “Barbarians at the vault”. It is the latest Economist cover showing a bank being besieged by a horde of angry “barbarians” carrying banners with such slogans as :

• Skin the fat cats!
• Just say no to CDOs
• Regulate now
• Salary limits

The building is on fire, there is a column being pulled and there are sledgehammers being taken to its pillars. Pretty powerful imagery. I wonder how it will play out with the Philadelphia Banking Index being where it is:

Check out the Economist’s “prowling bear” cover in 2006. As disclosure, I’m long the AMEX Financial Select Sector ETF (XLF).