Trader’s Narrative

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.

Sentiment surveys are a great way to measure what the masses are feeling. Are they scared? panicky? greedy? apathetic? There quite a few sentiment measures out there. They each try to measure some sort of sentiment: from investment newsletter writers to Mom and Pop retail investors, to institutional strategists and now, thanks to Birinyi Associates we even have a blogger sentiment survey.

To be useful, a survey has to provide an edge. That is to say, it has to be able to give some reasonable signal related to the market. Usually sentiment surveys are interpreted from a contrarian point of view. This inverts the results so that when the survey shows an extreme bearishness, it is interpreted to mean that it is a good time to buy.

But there is no reason why a sentiment measure has to be contrarian. It can also be accurate. That is bullish when it should be bullish and bearish when the market it topping. The worst sin a sentiment survey can commit is to have no edge.

And I’m afraid the Ticker Sense blogger sentiment poll is guilty of this. We have data for almost a full year now and no matter how we slice and dice it, it provides no edge whatsoever.

It’s most obvious characteristic is that while the market has been relentlessly going up, week after week, the poll shows a consistent preponderance of bears over bulls.

But before you think that this means that we can use it as a contrarian measure, consider the other side of the coin. The rare time that the poll has shown more bulls than bears - only 5 times! or around 10% of the time - it has not been a reliable indicator of a topping market.

Out of the five times the poll has seen more bulls, three of those have in fact been good buying opportunities (see graph below). I suspect they were times when the bloggers grudgingly gave in to a powerful bull market - albeit for a very very brief period of time.

Below you can see a chart showing this (green dots are instances of more bulls than bears). I didn’t put a red X on the chart everytime a bearish consensus proved to be false because that would make the chart as red as a butcher shop:

The conclusion I draw is that the poll is simply meaningless. It provides no significant piece of sentiment information we can use. At times it is bullish and at most other times bearish. But there is no connection whatsoever with the market.

This reminds of last year’s experiment by Barron’s with a proprietary sentiment concoction from the hallowed halls of Citibank. For week after week this sentiment measure treaded water at a level they had marked ‘panic’. The market went up, the market went down. And still Citi’s sentiment measure mumbled ‘panic’. After a few months of fielding complaints from readers Barron’s withdrew the metric.

That’s what I suspect will happen with Ticker Sense’s sentiment poll also. The market is ruthless. If something has no value, it is discarded.

While scanning the sentiment landscape, I noticed something quite extraordinary.

The latest AAII sentiment measure is showing 54% of respondents as being bearish. By itself, that’s not unusual since we’ve seen numbers like it before. What makes this bearish sentiment historic is that:

1. it is very bearish (significantly so)
2. it follows a rise, not a fall in the stock market

Never in the 20 year history of the AAII have we seen such a rise in bearishness coupled with a rising market.

Let me say that again, this has never happened. Whenever we’ve seen such extreme bearishness it has been after a significant market decline and has actually been a reliable signal of the formation of a bottom.

Yet, here we are. The latest survey shows almost 2 times more bears than bulls - after the market has rocketed higher almost everyday.

What does it mean?
Unless this is some calculation or reporting error on the part of the AAII it means that the retail, Mom’n'Pop investor is spooked by the recent rise in the market. They don’t trust it. They think it is fake. They think the market will actually fall. During the March 2007 market decline they were nervous but not this nervous! At the bottom of the March decline, they were 45% bearish. Now, even after a breathtaking market recovery, even after new highs, they are 9% points more nervous.

What implications does it have?
From a contrarian point of view, this may seem automatically to have bullish implications. But if people start to act on this bearish feeling by taking money out of the market… selling mutual funds, selling stocks, etc. then it may in fact be bearish. As long as they remain as “smart” unbelievers, on the sideline, this would be bullish.

The level of caution everywhere is rising faster than the stock market. I’ve noticed it on blogs (cough), newsletters, columnists, etc. As the Wall Street saying goes, bull markets climb a wall of worry. Right now, you can have your pick: inverted yield curve, dollar, GDP, stagflation, unemployment numbers, etc… The bears are great at creating laundry lists of such reasons.

Maximum Pain
But if something is obvious to everyone, then it doesn’t matter. The market behaves in such a way so as to inflict maximum damage to the maximum number of portfolios. Its job is to kick you off. Your job is to stay in and ride the trend.

This latest AAII sentiment number is certainly a curve ball. Should we take it at face value? or try to out smart it?

Whatever happens, it is exciting to live a never before seen moment in market history.

As Spock would say, Fascinating.

On a different note, I’ve continued to add articles, books and other choice trading related resources to my box.net widget. Make sure to check it out and let me know if you have any special requests.