Trader’s Narrative

Let’s face it, this market has been driven by technicals not by any real fundamental health. So what happens when the same folks leave and take their rationale with them, fundamental investors may not be as keen to support the bids.

The recent softening in bids shouldn’t be a surprise. On October 15th the S&P 500 briefly traded 20.81% above its long term moving average. Now, it is only 14% above it. It was back on September 16th that the S&P 500 index first reached the 20% Maginot Line. Between then and now we had 4 other instances where price briefly pierced minutely above the 20% barrier only to be pushed back. Compared to historical precedence, this is part for the course.

As I presented in the detailed historical research report (What Happens This Far Above The 200 Moving Average?), usually when price moves this much away from its long term trend it has been unable to continue at the same pace. That’s what we’re seeing today as the S&P 500 is now below where it was trading on September 16th.

In this short video you can see the headwinds arrayed against the S&P 500. Both by the breaking of the uptrend line from March 2009 and the approaching downtrend line from the top of the bear market (October 2007):

One of the most important sectors, the Philadelphia Banking Index (BKX) has broken this uptrend line. We are also seeing some serious breadth (advance decline) weakness which is never really good but especially bad news while the market is so near a top.

Two institutional money managers have turned negative on the market recently. Jeremy Grantham of GMO Partners and Bill Gross of PIMCO. Click here for details on Grantham’s reasoning and to download his full quarterly report. Gross goes further than Grantham saying: “almost all assets appear to be overvalued on a long-term basis”. You can read his full commentary here.

For those who like to look at fundamental data like the quaint P/E ratio, here is a very long term chart, courtesy of Prof. Shiller:

As you can see, a lot of air was let out of the bubble. But, to mix metaphors, the pendulum didn’t swing back enough. During previous important market lows, the P/E ratio has fallen to much humbler depths. Thanks to the 60% rally from the March lows, we are once again back above the long term average. Which is unsettling, especially when you remember that Shiller uses a 10 year smoothing of the earnings data to iron out short term noise.

October’s P/E earnings, according to Shiller’s methodology is about 20 - well above the long term historical average of 16. Normally, a P/E ratio of 20 corresponds to economic expansion in its 5th year, not a major recession like the one we’re experiencing now. So understandably, Prof. Shiller is skeptical of the recovery in the equity market making the inevitable comparison to the aftermath of the 1929 crash and saying that “it can’t be trusted to continue”.

And turning our attention momentarily to the options markets, the equity only ISE sentiment index came in today at 191. Which means that while the equity market had a negative day with red all over the monitor, retail option traders tenaciously clung to hope and bought almost twice as many calls.

And if all that wasn’t spooky enough for you, to coincide with Halloween this year we have the 80th anniversary of the Great Crash of 1929. Boo!

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Here’s this weeks’ sentiment overview:

Sentiment Surveys
According to ChartCraft’s Investors Intelligence survey, 40.4% of newsletter editors are bullish, while 31.5% are bearish. This ratio of bulls to bears takes us back to where we were in mid April 2009.

The US retail investor, as measured by the weekly AAII survey, has recovered quite well from the shell shocked state we found them in in early March 2009. In that sentiment overview, the AAII put in a new record bearish extreme with 70% expecting further declines in the stock market. Since then, they have recovered 37% points - that’s more than half.

So this week we are seeing a similar sentiment picture from the AAII survey: 44% bullish and 33% bearish. Check the link to see the only two other times in the history of this metric that we had seen such an extremely gloomy outlook from retail investors.

And finally, the AAII equity allocation jumped from 41% to 50% of portfolios. Most of this increase is coming from a reduction in cash holdings. While this may seem negative, it is required. Unless investors allocate more capital to equities, how can it appreciate? At the same time, the current allocation is still historically low; equal to late 2002 and early 2003, as well as early 1991 - all great times to jump back into the market.

Options Sentiment
The short term moving average of the CBOE put call ratio is about as low as in May 2008 - which was just before the market rolled over again and cascaded down into the November 2008 lows.

The ISE Sentiment is also showing similar levels of complacency. Today’s ratio was 191 - meaning that calls were purchases almost twice as much as puts. (not show on the chart below). That’s a little bit lower than the 225 call to put ratio from this Tuesday:

The previous high in this ratio occurred on December 30th 2008 (234) when the Santa Claus rally hit the wall. But notice that the high call buying cluster in mid April didn’t seem to faze the market in the least. The options market remains the one sentiment measure that has been strangely affected during this bear market. Maybe I’m not reading it correctly or maybe something structural has shifted. Either way, I’m growing wary of giving too much weight to it.

Volatility
After falling to a 6 month low in mid April, the CBOE Volatility Index (VIX) continues to drip lower. It is now below both its long term (200 day) and medium term (50 day) moving averages. As I pointed out before, while the VIX has been acting lethargic in comparison to the sprightly S&P 500, it seems to be begrudgingly confirming the rally.

While the VIX is saying that the market volatility is lower now than before, it doesn’t really feel that way to those that watch the tape every day. That’s because the market is just as volatile. As Mark Hulbert points out, if we count the number of days in which the market has risen or fallen 1% or more, it becomes apparent that we’ve seen as many of these ‘volatile’ days now as before when the VIX was almost three times as high.

Insider Activity
As mentioned before in a previous sentiment overview from a few weeks back, corporate insiders have started selling their company’s shares at a rapid pace. It is hard to believe but they’ve picked up the pace since then and pushed the ratio of sales to buys to a fresh highs.

Fund Flows
There is a change in the air. Investors are venturing out of their bunkers and taking on some risk. Equity mutual fund flows is now at a rate to be $8 billion for the month of May. While this may appear to be bad news, from a contrarian point of view, we have to keep in mind that any sustainable rally in the market requires fresh funds to fuel it.

As well US junk bond funds saw an $822 million inflow this week. So not only are investors taking on the kind of risk that comes with equity ownership, they are suddenly showing a very healthy appetite for the much more riskier asset class of junk bonds.

The Grey Beards
Once in a while I like to check in with the Grey Beards, the investment professionals that have seen more market action than most of us. Right now, they are for the most part bullish. Doug Kass of Seabreeze Partners, Jeremy Grantham of GMO and Richard Russell of Dow Theory Letters. Each of them has acknowledged that we are transitioning out of a bear market into a bull market. Some of them, like Russell, very grudgingly. By the way, I recently added Grantham’s latest client letter to the Free Trading Resource section (under Reports & Articles).

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