Trader’s Narrative

Here is the wrap up of this week’s sentiment data:

Sentiment Surveys
The weekly American Association of Individual Investors (AAII) stock sentiment survey shows a surprising increase in optimism. Of the respondents, 44% were bullish (a 5% increase from last week) and 35% were bearish (a 10% point drop from before). We aren’t near any sort of extreme level, however the direction of sentiment is puzzling since the stock market closed lower than it has for the past 18 days.

Investors Intelligence
The stock newsletter editors, as measured by ChartCraft’s Investors Intelligence, shows a similar increase in optimism. This week the II had 50.6% bulls (4% point increase from last week) and 23.6% bears (a 0.8% decrease). I’m not sure how helpful this is as the Investors Intelligence bull/bear ratio has been relentlessly hovering around 2:1 for the past few months.

In contrast to both of the above sentiment surveys, the Hulbert Stock Newsletter Sentiment index which measures a sub-set of market timing newsletters is showing a decline in bullishness. The HSNSI was at 45.2% when we hit an intra-day high of 1080 on the S&P 500 index. But now it stands at less than 29.1% a significant sentiment erosion in response to a small retreat in the index.

A recent survey of institutional investors by TheMarkets shows that an increasing number of them believe we have seen a definitive low. While in June 40% thought so, now 70% do. Furthermore, 90% of them expect the S&P 500 to climb to the 1200 level by the end of the year in 2011. Back in March only 50% were as optimistic about the S&P 500 reaching that goal.

Fund Flows
An estimated $29 billion was withdrawn from equity mutual funds (domestic) by US retail investors for the month of September. Meanwhile, they dove head first into fixed income funds by buying almost $46 billion worth of taxable and municipal bonds last month. This is a continuation of the trend which I highlighted before: Equity Mutual Funds Show Outflow Even After 60% Stock Market Rallly.

So if it isn’t Mom’n'Pop investors and it isn’t corporate insiders, who is buying? Leaving aside conspiracy theories of the Plunge Protection Team - because let’s face it, if they exist they are very bad at their job - we are left with opportunistic hedge funds. The usual suspects are either grey/black boxes or discretionary traders chasing a momentum market higher. Remove this remaining leg and the table get mighty wobbly.

Option Traders
The short term moving average for the ISEE sentiment index (equity only) fell slightly from last week’s high of 196. As you can see from the chart, these were gidy levels which we hadn’t seen since late 2007, just before the bear market began:

Zooming in on the week’s data, the ISE sentiment index hit a high of 204 on Tuesday but as the S&P 500 fell for the rest of the week, it actually registered a slightly more optimistic tone. I was watching to see if we would make it down to 100. But this small decline was not enough to rattle anyone in the ISE.

The CBOE put call ratio (equity only) reacted slighly more in response to the weakness in equities:

In contrast to the stubborn complacency shown in the ISE option data, the CBOE (equity only) put call ratio jumped to 0.84 on Friday - getting really close to the noteworthy 1 level. As well, the ratio increased every single day of the week, even on Monday when the S&P 500 closed higher.

Grey Beards
Checking in this week with a market guru who both literally and figuratively has earned the title of a ‘Grey Beard’. Steve Leuthold, the 71 year old money manager who is not afraid of going short, is very bullish right now.

Leuthold expects the S&P 500 to end the year at 1200 and even higher at 1350 next year. In keeping with that bullish view, he has 72 percent of his fund invested in equities.

“There’s pretty good momentum, and the market psychology is right. The markets turned up before the economy did. Now, the economy is improving. It might be a little better than most think. It ain’t wonderful, but it’s a lot better than it was.”

Meanwhile, Doug Kass and David Rosenberg as well as Bob Janjuah of RBS - all of whom I’ve mentioned before - remain decidedly bearish and unmoved.

Here is this week’s sentiment wrap-up:

Hulbert Newsletter Sentiment
One of the most important aspects of sentiment analysis is that it presents us with a snapshot into the mindset of the general investor at a pivotal moment - like a retest of a bottom. As the S&P 500 heads down towards its November lows once again, the sentiment picture doesn’t bode well for the bulls.

To see why, let’s go back to the last bear market low in 2002-2003. At that time the Hulbert Stock Newsletter Sentiment Index (HSNSI) hit +10% at the low in October 2002. This meant that the average market timing newsletter was suggesting a market exposure long of 10% of a client’s portfolio.

When the S&P 500 (SPX) melted back towards the 800 range the vast majority of people had given up on the market and instead of going long were suggesting shorting the market. That was a demonstrable show of capitulation on the part of die hard bulls and it was one of the reasons that we lifted off to a new bull market:

Now compare that to what we are seeing now. Since the low of 750 for the S&P 500 Index (SPX) the average market timing newsletter as measured by the HSNSI is actually more bullish!

Of course, this not only flashes a bright red caution light for the bulls, it dovetails nicely with all the other sentiment data we’ve been looking at recently.

Sentiment Surveys
According to the ChartCraft Investor’s Intelligence survey, the bulls increased slightly to 43% while the bears remained the same.

In contrast, the AAII sentiment survey showed a large drop in bullishness - from 48.70% to 27.63%. The bearish reading increased but not as much - from 35.06% to 47.37%.

ISEE Sentiment
There was no significant change to report with the ISE sentiment index.

General Sentiment Measures
I’ve outlined a few lesser known measures of general sentiment which are hitting very low or all time lows. If you missed them, they are the Conference Board Consumer Confidence and the State Street Investor Confidence Index.

Market Breadth
The percentage of S&P 500 stocks above their 10-day moving average is once again below 10%. This is usually a rare event but thanks to the tumultuous market of 2008 we have gotten used to seeing this more and more. Within a bull market this is usually a very good indicator of a significant bottom but in this market I wonder if it has the same significance.

Volatility
The CBOE volatility index has regained the 50 level once again (peaking at 55) but there it has met the declining 50 day moving average and the previous technical support line. My hunch is that this is a reaction to the rapid decline and volatility will continue to fall.

Is it just me or is this tape incredibly frustrating? We’re dripping lower, seemingly on our way to test the January lows. But it is anyone’s guess if we we’ll get a head fake lower and then reverse up or just cascade down into a continuous bear market decline, ala the 1970’s.

To help light the way, here is the sentiment overview for the past week:

Hulbert Newsletter Sentiment
According to Mark Hulbert, the keeper of the HSNSI (Hulbert Stock Newsletter Sentiment Index), there is contrarian arguments that the January low will be intact.

This week’s market decline brought down the portfolio allocation of stock newsletters to -16.4%. That means the average market timing newsletter iss advising their clients to be short the market.

The HSNSI is now not only below the January 22nd lows, it is the lowest such sentiment reading since October 2005 when it scraped -30%. The silver lining in the clouds is that newsletters are dejected and starting to throw in the towel. They are not stubborn in their denial of a declining market. That, according to contrarian analysis, sets the stage for a potential rally.

Option Market
As I pointed out yesterday, the CBOE’s equity only put call ratio spiked to a four year high. Today it retreated to 0.90 - still quite high but backing away from everest proportions.

On Friday it was the ISEE Sentiment Index’s day to turn heads. I suppose the retail traders read the headlines and watched the TV reports from Thursday’s trading, got freaked out of their minds and started buying puts hand over fist, pulling the ISE sentiment index fdown to 65 - the lowest it has been since January 17th of this year.

On that day the ISE index was 60, meaning that retail traders were only buying 60 calls for each 100 puts. Strangely enough, the market bottomed a few days later (January 22nd or 23rd, depending on whether you go by the intra-day low or the close) when the ISE ratio was much higher: 105 and 98!

This is exactly what happened during the March 2007 retest of the bottom. During the first decline, the ISE sentiment dipped to the 60’s but during the subsequent retest, it was at par (100).

AAII Sentiment Survey
Finally, among the sentiment surveys this week, the AAII results stand out with a meager 22% bullish and 50% bearish (again). During the January decline, the AAII survey showed similarly low bullishness but the rally it ignited was mild to say the least. You remember this chart, right?

We’ll have to wait a few more weeks to see if it will be borne out but it is an understatement that so far, it has been a disappointment. By the end of this month, we’ll have given it the 13 weeks it requires. Let’s see if the AAII contrarian sentiment analysis lives up to its history - mark your calendars!

Investor’s Intelligence
In agreement with the retail investors, this week’s Investor’s Intelligence sentiment survey shows the newsletters at 42% bullish and 37% bearish. Both those levels correspond to extremes, which can be interpreted according to contrarian thinking as very bullish for the market.

To wrap up, while we may have to endure some further turbulence due to our proximity to the January lows, the sentiment is horrible out there and it will set the stage for an intermediate to long term rally. The trick will be to not get shaken out of long positions while still maintaining discipline.

Well, that was something. Wasn’t it?

Simply breathtaking.

I love it when things align like that. I had to take care of some things yesterday or you would have found me gloating about this much earlier

An old saying around Wall Street is that the market moves to exert maximum pain to the maximum number of participants. If this isn’t what just happened, I don’t know what is. Who in their right mind could have foreseen what happened this week? the breakout? the sheer intensity and unrelenting buying pressure?

Unfortunately for them, those that bear the brunt of the damage tend to be the outsiders, the unwashed masses, otherwise known as retail investors and traders. For the most part, insiders make out just fine.

Speaking of insiders, the latest Commitment of Traders report, hot off the presses, shows a continuation of the same lopsided buying from the commercials. Brace yourself, because since the last report, commercials have increased their aggregate net long position by 36%.

Eventhough I was bullish as I outlined this past week, I was still taken aback by the force of the bulls. They simply demolished the bears. I don’t care what thesis a bear trots out: inflation, the dollar, China, etc… it is all meaningless in the face of such a clear and powerful breakout.

What’s more fascinating is that according to the Hulbert sentiment measures, newsletter publishers are not at all excited about the market… even as it has gone up. In fact, in the face of a rising market, sentiment has actually become less bullish. To be specific, in late February 2007, when the market was going strong (before the correction), bullish sentiment as measured by Hulbert, was 62.4%. Since then, the market has recovered the correction and then some. But newsletter bullish sentiment is now 40.6%

And Thursday’s rocket ride did not make one iota of difference! It seems like the newsletter writers out there are scoffing at the price action as merely a mirage. Who knows, it may very well be. But with history as a guide, we know that the probability of it being real is high when there isn’t much excitement accompanying market gains.

But (there’s always a but) the Investor’s Intelligence report on newletter sentiment shows a completely different picture. According to II there are 21.3% bears and 49.5% bulls. That is a fairly toxic ratio of bulls to bears. But if we look back to 2003 we see that after the bear market low was made, and as the market rallied almost continuously for the whole year, the sentiment was equally bearish according to II. So maybe history will repeat. But why are the sentiment measures so at odds?

I believe it is because Michael Burke and his team over at II use a different method to categorize newsletters. Rather than going by what the newsletters are recommending (which Hulbert does), they go by their feel of the bullishness or bearishness (or neutralness) of the newsletter after a reading. This is a much more subjective method and may account for the variance between the two sentiment measures. Ideally, we would like to see them agree with each other. But we can’t have everything now, can we?