Trader’s Narrative

For economic and market news and to see what interesting reading you may have missed last week, check out the list below. To see it all, go to news.tradersnarrative.com:

• How demographics holds the key to the stock market
• The most powerful banker you’ve never heard of
• Who Is in the Oil Futures Market and How Has It Changed?
• Does anyone watch Fox Business News?
• Get a FREE Subscription to Futures Magazine (limited time for US residents only)
• There’s No Such Thing as Idle Cash on the Sidelines
• Zombie ETFs
• Kass: Market Has Likely Topped
• “We were completely and officially ignored”
• Dogs of the Dow have struggled in recent years
• Hedge Funds Back in Hiring Mode
• Get the Elliott Wave Theorist for FREE (limited time)
• Dow By Any Other Name

For the complete list, follow the graphic link below to news.tradersnarrative.com:

And remember to check back regularly since there are interesting links added throughout the week.

Europe’s Week Ahead

If you would like to receive a free copy of Robert Dorfman’s book, Hedge Fund Trading Secrets, enter the draw by leaving a brief comment at the above link (making sure you leave your correct email).

The Canadian government introduced a really smart new way for its citizens to save for their future by introducing Tax Free Savings Accounts (TFSA).

These are special accounts that allow your assets to grow sheltered from taxes. You can contribute up to $5000 a year (the limit for 2009) with this limit rising with inflation in $500 increments. As well, any unused contribution limits can be carried forward. So let’s say that you don’t contribute for 5 years and then receive an inheritance of $25,000. You would be able to put that lump sum and have it grow tax free. But any contribution over the $5000 a year limit gets a 1% a month penalty (similar to Registered Retirement Savings Plans).

Unlike RRSPs, you don’t need to have any income to make contributions to a TFSA account. But neither will you receive any tax benefit for simply making such a contribution.

The really amazing thing is that you can also withdraw the money at any time with no tax consequences! So unlike a RESP or RRSP your money is not locked in. And since contribution limits are carried forward, when you make a withdrawal, you have increased the contribution amount for future years by the same amount.

But the real flexibility of this new account is that it can hold bonds, GICs, mutual funds, equities and equity options. So if you combine it with a brokerage account that would allow you to trade the account, you have the best of both worlds: a trading account which grows tax free!

Although I still like and recommend Interactive Brokers to active traders and even lackadaisical long term investors, for some reason, they refuse to offer registered plans (RRSPs, RESPs, or TFSAs).

Knowing Interactive Brokers’ penchant for thrift, it probably has to do with the cost and human labor involved with setting up and administering such accounts. So with Interactive Brokers out of the picture, Canadians who want to open up a TFSA are left with the usual options of the big banks as well as a few independent brokers.

I’ve looked at all the options out there, and for Canadians, the best option for a TFSA is Questrade.

If you are an IB client like me, something else that you may not have realized is that buried within the agreement you signed with Interactive Brokers, is a clause that says you must have another brokerage or trading account. So if you don’t already have a ‘back up’ account, this is a great way to set one up. Not only will you be earning tax free capital gains, dividends, interest, etc. but you will also be saving money by paying the lowest commission rate in Canada (second to IB).

Questrade Commissions
For equities, Questrade charges 1 cent a share, with a minimum of $4.95 and a maximum of $9.95 per trade. As well, with a regular Questrade account you can trade options, futures, forex, mutual funds and physical gold.

And on top of all that, as a reader of Trader’s Narrative, if you sign up using the link in the banner, you get $50 in free commissions! What else can you ask for?

With Questrade’s low commission structure and no annual fee, you can quickly transform your tax-free savings account into a tax-free trading account. Just imagine, within a few years of contributions, you can have $25,000+ growing tax free.

Disadvantages
Of course, the only disadvantage is that if you have losses in this account, you can’t use them to offset your taxes. So depending on how confident you are in your ability to be profitable in this account, you might want to use this as more of an investment account for high dividend paying stocks, REITs or bonds. But remember, since this is a registered account, you can trade and hold any asset in your Questrade TFSA account except forex and futures. And for the same reason, you can’t use margin - this is a cash account.

Since capital gains are already 50% tax-free, you might want to only include bonds or bond ETFs which would otherwise be taxed at the full amount. Another option is to take advantage of the bear market and buy a leveraged equity ETF to ride the recovery. Whatever your strategy, take the time to learn about this new option or speak with an advisor to find out how it can benefit you.

The sentiment landscape has changed much from just a month ago:

Sentiment Surveys
The AAII sentiment survey came in this week at 53% bulls - unchanged from last week. Not only is this a very high bullish reading for this indicator, it is the level at which the market topped out last October. Furthermore, the fact that it has remained firm in the light of this past week’s market performance should be sending chills down the spines of bulls.

From a contrarian point of view, I want to see the retail investors (AAII respondents) become fearful as the market is falling and remain so even as it rises. The fact that they have now quickly shuffled over from extreme bearishness to bullishness and maintained it for two weeks, even as the market fell, reinforces my belief that we are in for some trouble.

In contrast, the Investor’s Intelligence survey is showing 44.4% bulls and 32.3% bears. There was a slight increase in the bullish numbers and an even larger increase in the bearish camp. Still, according to the current II we aren’t anywhere near bullish extremes. Take for example that the bull/bear ratio is 1.37 - it was more than 3.0 when the market topped last October.

Rydex Nova/Ursa Ratio

In case you’re not familiar with this indicator: before the onslaught of ETFs, Rydex’s Ursa and Nova were the ticket if you wanted to time the market. The are mutual funds but they settled twice daily (I don’t think they do anymore) and you could switch assets between them or other Rydex funds with no penalty. Like other contrarian indicators, when the fast money crowds to one side, the smart thing to do is to jump to the other side.

Right now the ratio is showing an abundance of optimism from the Rydex fund timers. Something which makes me wary. On its own this wouldn’t be enough to really concern me but it is just one more in an ever growing list of short term indicators which suggest some sort of correction or pause at best.

Fund Flows
The only bright spot, from a contrarian perspective, in the sentiment overview is the mutual fund money flows. According to AMG Data, one of the largest and most accurate providers of this sort of data: domestic (US) mutual funds reported net redemptions (outflows) of $8.6 Billion. This dovetails with the panicky behavior we’re seeing in Canada.

With interest rates so low, and cash being basically a negative return investment, you won’t be surprised to learn that money market funds had the largest monthly outflow in April ever on record: $78.7 Billion. Some of the cash flowed into municipal bond funds ($4 B), no doubt in search of a higher yield. But I suspect much of it, perhaps even the vast majority, was the US consumer’s retrenchment.

Finally, among the sectors, real estate funds received the largest inflow of money since February 2007 - which was exactly the worst time to buy REITs or anything else real estate related in the stock market.

So while this beleaguered sector has valiantly fought back from the January 2008 lows, it may be about to top out (again). Look alive out there.

The trend in the fund flows data continues. Investors are shunning the US stock market and embracing the international equity markets.

According to AMG Data: for the month of May 2007, domestic funds reported an outflow of $5.2 billion while non-domestic funds report net inflows of $11.6 billion.

For the month of June 2007, domestic funds report net outflows of $4.2 billion while non-domestic funds report net inflows of $9.3 billion.

The only other market which is even close to as unloved as the US is the Japanese market. Every other market, emerging and developed gets some love (aka capital).

While this dovetails nicely with the other data suggesting the retail investor’s apathy towards the US stock market, in the long run it can’t be good. Typically, a bull market starts out with everyone being skeptical and ends when no one is.

But the market needs the participation of the regular guy. Right now we are seeing the “smart money”, commercials falling over themselves to get long. This is a fantastic vote of confidence in the intermediate to long term. But they can’t sustain the market forever.

While sentiment data and my proprietary sheeple index are interesting, they are both circumstantial evidence.

To see what people are actually doing, we have to look at funds flow or liquidity data. The last time I brought this up was last summer when a skittish public started pulling out significant funds as a result of a small correction in the markets. That had panic written all over it and as a contrarian, one would interpret it as bullish since it took very little to scare people enough to have them pull money out.

Right now we aren’t seeing that sort of fear in the market. However, as we have come to suspect from the other evidence (sentiment and traffic data of online brokers), the retail investors are not believers in the US markets. In fact, they are putting money to work everywhere and anywhere except the US markets.

According to AMG Data: Last week, for data including ETFs, investors pulled $1.6 billion out of the US markets and in contrast, sent around $700 million to work in non-domestic destinations. In April domestic funds saw net outflows of -$4.9 billion while non-domestic funds reported net inflows of $20.2 billion.

So while the average investor is shunning the US markets, they are hitting within spitting distance of all time highs. Interesting. Where are they putting their money? In the emerging markets: Asia (except Japan), Latin America (especially Brazil and Mexico), Russia and Western Europe.

In the face of such evidence, I wonder how people can continue to call this market “frothy”? or the price action, “a melt up”?

But although funds flow data is an accurate and meaningful gauge, it must be approached wtih the right time frame. As the example from last summer, it works great when you have a medium to long term point of view. Anything shorter and it isn’t really helpful.

While a bull market requires active participation by the retail investor, today it is the private-equity sector who is the primary force behind the demand for equities. Every day we read about one large deal either rumoured, announced or concluded. My take is that as the market moves higher, the retail investors will ultimately succumb and start to buy stocks again. And finally, as in all cycles, in the later stages we’ll have a real “melt up” and “froth” as the masses rush to invest in a hot market.

But until then, we’ve got a long ways to go.