Trader’s Narrative

This week the sentiment data brings a very intriguing turn of events so let’s get started:

Sentiment Surveys
The star this week is the ever so humble and common AAII weekly survey of US retail investors. This sentiment indicator sends extreme signals every once in a blue moon. So I guess you better check the night sky tonight because we haven’t seen so few bulls in this survey in a long time.

This week’s AAII results show only 22% bulls and a whopping 56% bears. The last time we saw this few optimists and this many pessimists was the week of February 19th 2009. Just before the spring rally. To put that in (even more) perspective, out of all the data that we have so far, only 4% of the time have there been less bulls.

Here is a chart of the bull ratio (bulls divided by the total number of bulls & bears):

I’ve zoomed in to the past 7 years or so since showing the whole time series from 1987 would be overkill. From 2002 till now, there have been 8 instances where the AAII bull ratio was less than 30%. But as the last extreme reading in February suggests, it is best to not act in haste when presented with such a scrumptious contrarian gift. Historical data suggests that sitting on your hands for the next few weeks is the most prudent strategy (for longs).

I hope that I haven’t understated the gravity of this week’s AAII sentiment survey result because there is a high probability that it will once again prove to be prescient in pinpointing an upcoming inflection point. It is most definitely a tell that after a 55% rally we find the AAII bull ratio at such an extreme low when in early 2004 after a 37% rally from the 2003 lows the bull ratio was at the other extreme (see above chart).

The one puzzling thing is that the AAII asset allocation survey shows a slight uptick in equities (to 57%) while back in February when the bull ratio was so low last, it was closer to 40%. I guess the message the AAII folks are sending is that they like equities longer term but short term they’re very nervous. And that’s remarkable because of how little off we are from the year’s highs.

Investors Intelligence
While this week the AAII deservedly monopolized our attention, the measure of newsletter sentiment from ChartCraft is a snoozefest. The II this week is almost completely unchanged with 48.3% bears and 24.7% bears for a (yet again) bear to bull ratio of 2:1. I’m not sure how to reconcile these two disparate metrics but I do know that this is really nothing new as they often conflict with one another.

Hulbert Newsletter Sentiment
Thankfully, we have another measure of newsletter sentiment. Currently, the Hulbert Stock Newsletter Sentiment Index (HSNSI) stands at 3.2% - which implies that the average recommended exposure by short term timing newsletters is to be long 3.2% of their client’s portfolio.
Continue reading ‘Sentiment Overview: Week Of November 6th, 2009′

The poor besieged dollar gets a short reprieve as the gold bull market pauses. But the gold bugs suddenly have an unexpected and persuasive ally in their camp. As an interesting addendum to what’s next for gold? in the most recent quarterly client letter, Paul Tudor Jones II builds a fundamental case for a long term bull market.

He compares the relative historical value of the precious metal to the US monetary base, crude oil and the S&P 500 index. Their econometric model declares “gold is 20% undervalued over the next 24 months”. But the rationale is not restricted to the monetary forces which are at play.

Strengthening his case, he delves into the basic demand and supply of the commodity. On the supply side, mining production has been stagnant for the past 10 years. And central bank selling has slowed to a trickle with no new sales planned in the future.

On the demand side, the physical investment allure of gold continues strong. As well, to that we can add the penchant of modern investors for digital investment in gold. Relative to the gargantuan size of the equity market, the bond market and alternative investments (real estate, timber, etc.) gold’s share continues to be lilliputian. This means that even a sliver of asset flows diverted to gold will dramatically alter the equation.

Source: Tudor Investment 3rd Quarter Letter

Gold ETF holdings as a ratio of above ground stocks has increased incrementally 4 years. And the trend, does not look like it is about to reverse.

While Paul T. Jones presents a text book case for the long term bull based on fundamental analysis, I can’t help but think it is all an elaborate window dressing to rationalize a position he has arrived at through other, shall we say, more esoteric means. Clients obviously prefer logical, well thought out reasons for why a professional is allocating their money a certain way.

No one would be comfortable to be told that their trust fund is being gambled on nothing more than squiggles and trend lines or better yet, something called Elliott Wave (which we know, by the way, that Paul T. Jones II used to make a killing on Black Monday while practically everyone else on Wall Street was busy having an aneurysm). Interestingly enough right now Elliott Wave is bearish on gold.

This is just speculation on my part, of course. I have no way of knowing exactly why Tudor Investments is bullish on gold. Maybe I’m too cynical and we can take them at face value. In any case, even if the long term gold case is solid, you might want to fine tune the entry by looking at the gold sector sentiment.

Here is a chart comparing the price of gold and the Hulbert Gold Sentiment Index, which measures a subset of newsletters which time the gold stock sector:

Source: Risk Management and Convex Return Profiles

While the Hulbert gold sentiment metric isn’t as high as we’ve seen it historically, at these levels it does not bode well for another leg up. At least not without a pause first. As I mentioned before, to me it isn’t just the altitude of the bullish sentiment, it is also the attitude: as gold has corrected recently sentiment continues to reflect the same amount of optimism.

We went from lukewarm, boring sentiment overviews to white hot. As the saying goes, “May you live in interesting times”.

Volatility Indices
I complained in last week’s sentiment overview and the VIX responded giving us a real spike to 42.16 (VXN to 40.44).

These are levels at which we can comfortably say there is true fear in the market. And although there is nothing to stop us from actually seeing higher volatility numbers, there is no doubt now that we have crossed into the serious.

CBOE Put Call Ratio
It was a little dissapointing to not see this measure of fear spike higher. The spike only took the equity only put call ratio to 1.18 - a respectable level of fear but not even close to previous records. For example, consider that going back just a few months to March 2008, we saw 1.35 - as well, the ratio collapsed to 0.51 by the close of Friday’s trading.

ISEE Sentiment
The ISEE sentiment index measures the level of interest from the retail options trader in calls and puts with the resulting number representing a fear index of sorts. Not surprisingly, Friday’s level of 66 is one of the lowest we’ve seen.

The record was set on March 10th, 2008 with a paltry reading of 56, meaning that almost half the amount of calls were traded to puts.

Previous ISEE ratios below Friday’s are:

March 8th, 2007 — 58
October 11th, 2002 — 60
August 22nd, 2006 — 63

And on March 7th, 2007 and July 3rd, 2007 the ratio was tied with (September 19th, 2008) Friday’s at 66.

What is remarkable is not the low number we saw on Friday because after all, that is to be expected when the market is in shambles, but that there is a total disconnect between the two. Let me explain. While the market was careening lower on Monday and Wednesday, the retail options traders as measured by the ISEE were yawning their way to actually trading more calls than puts, putting the ratio slightly above 100.

Then on Thursday and Friday as the stock market screamed higher, the ISEE ratio fell precipitously as the retail traders furiously bought puts over calls.

So can this possibly mean?

Assuming that the data is correct, one way to interpret it is that what we saw in the final days of the week was simply the mother of all short squeezes (courtesy of the US government).

It would be premature to interpret the seemingly bullish market action to mean that buyers have reasserted themselves and buried the sellers in an orgy borne of relief. As I mentioned when I railed against the government’s temporary ban on short selling, each share sold short represents a future buy order. What we saw in effect was all those future buy orders which would have naturally have been traded over months and weeks, jammed through in a matter of days.

So it seems that not only is the retail options trader not buying this rally at all, they are finally getting seriously worried.

Lowry’s 90% Up Day?
I got a lot of people asking me if what we saw was the endangered 90/90 up day as defined by Lowry’s Research. Intuitively it felt like one and the numbers bear it out - almost.

To be precise, we saw 89.5% and 87.8% upside volume on the NYSE which is 90% if you squint. I don’t want to go around second guessing valued indicators but I can’t help but get a nagging feeling that a rally caused by the government interfering with the normal working order of the market just isn’t genuine.

Sentiment Surveys
The Investor’s Intelligence survey results are as of September 16th, which was before Thursday’s harrowing down day. Still, there was a significant uptick in bearish sentiment with 43.7% of newsletter editors pessimistic and 37.9% optimistic. Next week’s survey will be much more meaningful as it will demonstrate whether the recovery by the end of the week is perceived to be the real deal or not.

The AAII sentiment survey came in for the second week in a row with more than half the respondents bearish: bulls 27.21% neutral 18.37% bears 54.42%. Within a strong bull market this would be enough to get any contrarian excited but we’ve seen +50% AAII bearishness this before and it has disappointing at times. But the historical pattern is still on our side with the market bouncing back impressively on average after similar situations.

Finally, the Hulbert newsletter sentiment index which measures a subset of the stock newsletters which time the market did fall to -36.6% at the beginning of the week but recovered to -35.9% on Thursday. This is meaningfully low but unfortunately it is not even as pessimistic as what we saw in July when the market was trading higher than now.

Conclusion
Undoubtedly we are seeing major fear in the market and trusted indicators are almost unanimously pointing to the same conclusion. What muddies the water is not only the severity of the financial crisis which dwarfs the others we have weathered previously, making comparisons moot, but also the internationally coordinated government interventions which interfere with the normal course of the markets.

Here is a quick wrap up of the sentiment developments for the past week:

AAII
The retail investor’s sentiment flipped after two weeks to one where bears (45.45%) now outnumber the bulls (30.68%). The bearish sentiment, while high, isn’t at extremes. So a mildly bullish case can be made through contrarian analysis.

Investor’s Intelligence
The bulls and bears continued their stalemate as measured by this sentiment indicator. Both camps are 39.3% with 21.4% on the sidelines. Unfortunately, this doesn’t offer us any edge. And it hasn’t for the whole month of August with both bears and bulls being consistently equal to one another.

CBOE Put Call Ratio
The put/call ratio is middle of the range, closing on Friday at 0.68 (equity only). Nothing from this indicator in the past week, or even this whole month, provides any real insight. Lukewarm sentiment served with a side of bland.

ISEE Sentiment
This indicator is similar to the CBOE put call ratio, but it only includes retail option trades (stripping out market making and institutional activity) and it also upends the ratio, placing puts in the denominator.

On Thursday, August 28th 2008 it hit an extreme level of 162 - almost twice what it was at the beginning of the month. But the level wasn’t just noteworthy because of it’s numerical height.

Thursday’s ratio was also noteworthy because it broke above the two standard deviation (from it’s 6 month average) barrier. This is usually a negative development because it means that the average option trader is much more interested in buying calls than puts. The market has not responded well these extreme ISEE Sentiment readings. They have resulted in mild losses going forward.

Hulbert Newsletter Sentiment
While the market has gone sideways for the past two months, the sentiment of stock market newsletter writers, as measured by the Hulbert Stock Newsletter Sentiment Index has actually improved!

Consider this: the S&P 500 closed on July 1st 2008 at 1284.91 and at the beginning of this past week at 1266.84 - almost the same level.

But while two months ago the newsletters were suggesting an average exposure of -42.9% (that is to sell short the market), recently that exposure recommendation is -1.3%.

Major Lows Need Two Things
The problem with the market is that while we have seen capitulation extremes, in March and in July, everyone is too eager to believe that the worst is over.

Major market bottoms need more than extremes readings in indicators and panicked selling. They require that the majority of the market participants continue to avoid the market and disbelieve in the ensuing recovery.