Trader’s Narrative

Here’s an interesting chart from Merrill Lunch’s recent “Hedge Fund Monitor” report. It shows that traditional long short hedge funds have returned to a historically normal market exposure after the shock late last year:

With the end of the year barreling closer, hedge funds, like any other money manager out there wants to coast to an easy finish and hang on to their gains to be able to bank their lucrative incentive fees. One safe strategy is to sell their long positions and replace them with calls to have the best of both worlds.

This may explain one of the only places where we’re seeing some cautionary signs of exuberance. In last week’s sentiment overview I mentioned that the options pits is showing an awful lot of calls being bought relative to puts. While I’m hesitant to outright dismiss any irksome metric, some of that can be explained away by the penchant to lock in gains via calls. However, not all of it can be attributed to portfolio managers trying to coast to large Christmas bonus. That’s because the ISE sentiment which exclusively measures retail option traders is showing similar indications of exuberance.

Another interesting tidbit from the ML report is that hedge funds have on average reduced their exposure to ‘high quality’ stocks since April 2009. That makes sense since retreating into safer issues is a tried and true strategy in times of distress. Right now though, more speculative equities are getting most of the love. And that’s exactly what we’re seeing in the breadth measures as almost every single Nasdaq and NYSE stock participates in the rally.

You can download the whole Merrill Lynch report from the FREE trading resource section (check in the Reports & Articles folder).

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

The following is a run down of this past week’s sentiment data:

Sentiment Surveys
Let’s start by looking over some of the well known sentiment surveys:

The retail investors sentiment as measured by the AAII survey was equally balanced with bears and bulls both at 39% - and the rest undecided. To arrive at the tie, the bullish camp shrank by 9% points and the bears increased minimally (2% points).

ChartCraft’s Investors Intelligence continued to grow more bullish this week with 47.7% bulls and 23.3% bears (with the rest neutral). That’s more than twice as many bulls as bears! The last time we had this much optimism from this measure of newsletter editors’ sentiment was in December 2007. Interestingly enough, the S&P 500 back then was trying to get above its 200 day moving average - it didn’t succeed for too many days.

The Hulbert Stock Newsletter Sentiment Index (HSNSI) confirms the II data showing that the average equity exposure has increased by 60% points since early March 2009. Although some shift in sentiment is normal at the end of a bear market, this is double the average increase in the first 3 months of previous bull markets.

Rydex Ratio
We haven’t looked at the fast money traders in Rydex mutual funds. They have recovered from the March extremes but we are a ways yet from reaching the other side of the graph:

Option Traders

The CBOE put call ratio (equity only) fell to 0.55 on Thursday. That is a level which, while not being an extreme low, is low enough to show considerable confidence in the stock market. In effect, there were almost twice as many calls traded as puts (twice as many bets that the market would go up, as opposed to down). Other than this small blip, the larger picture hasn’t changed much since the last chart I featured in the sentiment overview last month.

The ISEE Sentiment data was even more lukewarm, offering no real clues from a contrarian perspective. The ISE equity only call put ratio was 191 which is relatively high. But we’ve seen a few isolated instances at this level before and it hasn’t been enough to stop prices from rising.

Hedge Funds
The latest data from Hedge Fund Research shows the average hedge fund 45% net long (as of May 19th 2009). That’s up from 33% earlier in the year but not as long as one year ago. The good news for the bulls is that there is still a lot of dry powder in hedge-land waiting to be deployed (especially if the market keeps going up and forces hedge fund traders to get off the fence). The bad news is that the so called ’smart money’ hasn’t really believed in this rally… yet.

Last summer I showed the inflation adjusted price of crude oil - below is the updated chart:

Source: Chart of the Day

It really puts last year’s crude oil bubble into proper perspective. Not only was it about 30% more intense than the 1970’s oil shock, it towers over the other price spikes we’ve seen.

What is even more peculiar is that this bubble was entirely artificial. It was not due to any geopolitical rationale, nor was it because of a supply/demand imbalance. It was entirely concocted out of thin air by large traders.

The world economy was fragile because of excess credit and speculation. Oil was the first domino to topple and knock the others down by slowing down the economy to reveal the rot under the surface. If it wasn’t the main cause of the worldwide economic slowdown, it was definitely one of the leading reasons for its severity. Although the connection needs no explanation, you can clearly see that every single recession was either preceded by or coincided with a large increase in the price of oil.

The crazy part of all this is that no sooner had the dance ended that the same players started dancing all over again. Hedge funds and large players are once again stampeding back into crude oil and commodities. After bottoming in February 2009, crude oil has doubled in price! That’s a little over 3 months ago!

And once again, there is absolutely no rationale for such a move. What? Have we suddenly lost our previous reserves of oil? is production somehow curtailed by war? or geopolitical unrest? or perhaps the market believes that the world will suddenly consume much more oil than it did before the recession?

As a trader, we don’t really care whether there is a legitimate move or manipulated by deep pockets. But at the same time, if you’re going long and letting the trend take you for a ride, just remember the difference between turkeys that get caught up in a tornado and eagles. One comes down to earth with a thud. The other soars majestically, landing at a time and place of its choosing.

A few weeks before crude oil topped out at $147.90 in July 2008, I kept pointing out that something was just not right with that market. In “What is Really Going on With the Price of Crude Oil?” I pointed out the role of large institutional funds and a few days later I showed a graph of the inflation adjusted price of crude oil which should have put the question to rest.

Follow the above link to see the chart because I truly marvel at how anyone could have looked at that and not realized that what we were seeing was not “peak oil” but the same imbalance that any run of the mill bubble produces. The 2008 run-up dwarfed both the late 1970’s oil shock and the 1991 Persian Gulf war spike.

Since then, we’ve seen the great unwinding of that frenzy take oil down to $35 - less than a quarter of its high in 2008. But now hedge funds and large institutional traders are, once again, returning to commodities in a big way. Below is a chart of the large speculators’ net long positions according to the US Commodity Futures Trading Commission:

Source: Bloomberg

Of course this shows all 20 major commodities monitored by the CFTC. Oil is in there somewhere having recovered its 200 day moving average, and risen 85% from its low in late 2008. But the money is flowing to agricultural products, metals and softs as well.

All that it will take is for the large speculators to pile on as they did before and the commodity bull will become a self-fulfilling prophecy. While that may nip the ‘green shoots’ it may also cancel out any remaining deflationary pressures.