Trader’s Narrative

While we’re on the subject of seasonality and how September is the albatross around the stock market’s neck these days, I’d be remiss to not point out that what has been historically negative for equities has been a boon for gold and gold stocks.

Last year, I also pointed out the positive seasonality of gold in September (and the remaining months left in the year). But, as measured by the Philadelphia Gold Bugs Index (HUI) gold stocks didn’t follow their historical path and finished the month pretty much unchanged. However, in mid-September there was a rally that took the Gold Bugs index 35% higher within the month.

In any case, here is a chart of the monthly performance of gold for the past 5 and 15 years:

If you compare this chart with a longer duration seasonality chart you’ll notice that during this current super-bull market for gold (which started in 2000) seasonality has shifted slightly. For these most current years (red line) there are really two big waves of positive seasonality for gold and gold stocks. The first is about to start while the second comes after a correction in October and lasts from mid-October to February of the following year.

Here’s a chart of the Gold Bugs index with the past two September’s and this year’s marked by a green arrow:

I didn’t bother marking the obvious triangle pattern that has formed in the gold stocks index. Prices are getting coiled into a spring and will potentially break out. However, over-head resistance is just 100 points higher at 475-500 - where the Gold Bugs index hit a wall early last year.

Remember, seasonality, while having a powerful and undeniable influence, is a secondary driver of prices. It is more helpful to think of it as context for the actual analysis of trend.

Equities, as an asset class are supposed to beat everything else in the long run. But how long is the long run supposed to be?

Is 10 years enough to be considered long run? For the past decade, equities, as measured by the S&P 500 index have been the worst asset class:

The ultimate shaming is that even a risk-free money market rate beat the dividend reinvested returns provided by US stocks. As for the other asset classes, they left equities in their dust. For me, the most surprising is the high return provided by long term government bonds. Of course, by far the best asset class was gold.

The last time we looked at this metric was in February (thanks to a chart from the New York Times). Then, the 10 year inflation adjusted return was -5.1%.

Here’s a chart of the S&P 500 index showing how we’ve see-sawed above and below the 1000 level more than a few times:

And while this is pretty horrific to anyone who was invested in equities for the past 10 years and actually expected the proverbial 10% p.a. return, it may not all be gloom and doom going forward. That’s because such negative returns over rolling 10 year periods are actually quite rare. Looking at a graph of the 10 year returns of the S&P 500 index, you notice that whenever things get this ugly, forward returns are very good. You can check out the chart in the commentary I wrote back in late November 2008: Why Long Term Investors Should Consider Buying.

That was written when the S&P 500 had an 8 handle. It dropped significantly lower so anyone with a long term time horizon would have gotten in early. But they would still be doing well right now.

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Welcome to 2009 and the first trading day of the new year!

The last sentiment overview of 2008 didn’t paint a pretty picture. And it seems that things have continued to deteriorate from there.

CBOE Put Call Ratio
Here’s a chart of the 15 day simple moving average of the CBOE put call ratio (equity only):

Unless you zoom out you will miss that in the past few years this indicator has fallen into a rather clear upward channel. In light of this channel, we are now very close to a bearish low for the put call ratio. As you can see, in the past this has coincided with very weak markets going forward.

ISE Sentiment
Surprisingly, just before the stock market got a year end boost - the S&P 500 rising from 870 to 930 - the ISE Sentiment index reached 206 on December 29th 2008.

The last time the ISE Sentiment index was close to this level was back on October 29th 2007 when it reached 192. Before that, the last time the call put ratio was above 200 was in May 2006, just before the market entered a period of weakness lasting until October of the same year.

If we look at the equity only ISE Sentiment data, the recent top came on the second to last day of trading of the year, on December 30th 2008 when it reached 234 - meaning that retail option traders on the ISE exchange bought over twice as many call options as put options. The last time this bearish level was surpassed was in October 2007. So obviously this is an ominous warning for anyone who is long this market.

Here’s a chart of the ISEE sentiment ratio (equity only):

Silver Lining
The only bright spot I can find in sentiment land is the recent data regarding portfolio allocation from the AAII. I’ve mentioned this before back in the sentiment overview for the week of October 3rd 2008.

According to the survey respondents at AAII, in October of last year, the retail investor in the US allocated 35% in cash, 51% equities and the rest in bonds. They have now moved to 42% cash and only 42% equities (and the rest in bonds).

This is significant because for the whole history of this indicator, retail investors have never allocated as much (or more) cash as equities. Clearly, this shows a despondency which contrarian investors spend most of their days sighing for in vain.

Although we have now surpassed any historical equivalent of an extreme for this sentiment indicator, it is interesting to note that the last two times that the allocation for cash and equities came close (but didn’t match) was in late 1990 and late 2002. Both brilliant spots to put cash to good use.

This dovetails well with some other reasons already outlined for long term optimism. It seems that we are in for a rough patch in the short term but clear sailing for those who will grit their teeth and bear it. No pun intended