Trader’s Narrative

Here’s this past week’s sentiment overview:

AAII Sentiment
The weekly AAII sentiment survey showed that 33% of respondents are bulls, up 8% points from last week. And 39% are bears, down 5% points from last week. Nothing really exciting here.

But something else that the American Association of Individual Investors monitors is how their members allocate assets within their portfolio: stocks, bonds, and cash. As you would expect, right now the average investor is shell-shocked and feeling risk averse. After dipping below the 2002 bear market low, their allocation to stocks has recovered slightly to appx. 45%.

Instead of seeking the shelter of cash, the average investor as measured by AAII, is plowing the money they took out of equities into bonds. So much so that right now they are allocating the most they have been since 1994. So consider this extreme bullishness in bond sentiment to be yet another rationale for a bubble in bonds.

Investors Intelligence
From the other sentiment survey, the newsletter editors continue to be an ambivalent lot for the most part. This week’s sentiment survey conducted by ChartCraft had 32.3% bulls and 38.7% bears. The bears are reasserting themselves but it is still too close for anything resembling a signal for contrarians.

OEX Put Call Ratio
Both of the options sentiment ratios that I usually monitor (CBOE put call ratio and the ISE sentiment index) are not telling us much right now. Fortunately, the OEX put call ratio is different. Although it is not as well known as the other two, I mentioned it before back on October 23rd, 2008: What’s up with this crazy options market?

Right now, this option sentiment ratio is even lower than it was then. In fact, right now the OEX put call ratio (10 day moving average) is lower than it has been for the past 20+ years. If you really wanted to find a lower reading, it would have to be Black Monday 1987.

Since the OEX options market is considerably smaller and it is generally believed that it is the playground of the ’smart money’, it is not interpreted as a contrarian signal when we have a preponderance of call buying, as we do now.

Hulbert Newsletter Sentiment
According to Mark Hulbert, the Hulbert Newsletter Sentiment Index (HSNSI) reacted quite unexpectedly to the Geithner press conference. Even though the market fell, HSNSI rose from -7.2% last week to +2%!

Mutual Fund Cash Positions
The more cash mutual funds hold in their portfolios, the more pessimistic the asset managers are. And more importantly, the more ammunition there is to continue the next bull market (when it starts).

From 2001 to mid 2007, mutual fund cash holdings continued to decrease - reaching an all time low at around 3.5%. As a result of the current bear market, the cash reserves have been increasing and are now around 5.2%.

But as Jason Goepfert brought to light, comparing the amount of cash over time isn’t very useful because at different times there are differing monetary conditions (interest rates, inflation, etc.). So he came up with a way to strip away these variables to allow for a historic comparison to be made. You can find his paper on this in the Free Trading Resource section (Charles H. Dow Awards folder).

Right now this standardized measure is showing that current mutual fund cash reserves are at higher comparable levels than the last bear market. But not as high as the early 1990’s.

Magazine Cover Indicator
Thanks to a reader from Germany for pointing out an interesting magazine cover indicator across the pond. Focus Money’s current cover (on the left) shows a very dark map of the world with the word “VORSICHT” in red - meaning: Caution! or Danger!. And below it, ‘Weltwirtschaftskrise’, literally meaning ‘world economic crisis’ but mostly used to refer to the Great Depression of the 1930’s.

The previous weeks’ covers weren’t much more cheerful either. They promoted ’safe’ investments like gold, bonds, convertibles, fixed income funds, etc. Since Focus Money is usually a very cheerful and optimistic publication that pushes stocks, this is a rare occurrence. And it is even more significant when you consider that the last time Focus Money had such somber covers guiding readers away from risk was back in February of 2003.

Hedge Fund Exposure
According to data from Carpenter Analytics, hedge fund exposure is slightly net short, as it has been from early 2008. This correct net posture is not surprising when you consider the depth of resources and talent at their disposal. However, the current net short exposure is very small compared to what we saw in the same measure in the last bear market. On the plus side, hedge funds are now much less short than they were during the waterfall declines of 2008.

What a week. This will go down in history so make sure you pause and take note. Wall Street just had its worst week in history. So how is the sentiment landscape?

Sentiment Surveys
As I hinted earlier in the week, we saw some downright gloomy sentiment from all the usual surveys. Investor’s Intelligence, which monitors newsletter writers sentiment came in at only 25.3% bullish and a whopping 53% bearish. This is the lowest number of bulls since 1994!

Of the AAII weekly sentiment respondents, 60.8% believe we are in for more downside while only 31.5% are bullish (the remaining few are ambivalent). This is the second highest level of bearishness from the AAII sentiment survey. The last time was on October 1990. For a graph see: AAII Sentiment.

Anecdotal
I’m hearing a lot of fear and loathing from all corners. Trader Mike’s blog is getting a lot of traffic coming in from people googling “how to short” which is always a sign of capitulation of some sort. Regular folks are disgusted with the market and fearful of their retirement security. You can see comedians and commentators on TV talking about the stock market every night. Steve Cohen, the legendary hedge fund virtuoso, apparently threw in the towel and told his whole trading floor: “You’re all idiots. We’re going to cash. I’ll see you in January.”

Rydex Market Timers
Before the rise of the ETF phenomena, the Rydex funds were the only vehicle which allowed market timers to jump in and out of the market, and to even take short positions (by buying a fund). Although ETFs have definitely eroded the popularity of Rydex compared to when it was the only game in town, they still have a very strong following.

Right now these market timers have skewed the asset ratio to a degree that we haven’t seen since the bottom of the bear market in 2002 and early 2003. Of the the total assets held in the Rydex S&P 500 Index funds, only 15% are long.

Hulbert Newsletter Sentiment
At the start of the week the Hulbert Stock Newsletter Sentiment Index (HSNSI) was -36.1%. Meaning that the average short term market timing stock newsletter was suggesting to their readers that they allocate that percentage of their portfolios as a short position. Going by absolute numbers, that is a very low reading.

But just a few months ago in July, the HSNSI was even lower at -42.9%, when the market was trading at a much higher price than now. To put both in perspective, in the aftermath of the September 11th terrorist attacks on the WTC, the HSNSI dropped to -13%. The lowest it got in the ensuing bear market was in July 2002 -15.14% and then a bit lower, -19.2% on March 10th, 2003.

Option Markets
I’m still puzzled by the way the options market has been acting because I expected it to show much more fear than it has. For example, the CBOE put call ratio (equity only) hasn’t even taken out the highs we saw in September (1.18), never mind those of March 2008 (1.35). The ISEE sentiment ratio also continues to show a total disregard for put options from retail traders. With the exception of Tuesday which saw it drop slightly below par, the ratio has shown that retail traders are actually opening more call than put positions!

Volatility
Are you sitting down? This week we saw implied volatility levels which eclipsed the 1987 Black Monday crash. The CBOE volatility index wasn’t trading or calculated back then, obviously. But it is “reconstituted” as if it were. The old method took volatility (VXO) to 86% (intraday high of 103%) . The new method (VIX) to 66% (high of 77%) and for the Nasdaq (VXN) 71.6& (intra day high 82.4%). It’s a good thing we are no longer using paper for charting or we would have to glue on a top piece to the right side edge of the graphing sheet.

Contra Hour Stand
The bulls made a brave stand at 3pm, otherwise known as “contra hour”. But in the end they failed to close above or even break even. Monday is round two. Lets see what the G7 meeting can accomplish.

Headline & Magazine Covers
You don’t have to look far to find incredibly bombastic headlines. Some would say they fit the times. Others that in hindsight they will be another sign of contrarian opinion. Here are two from the Economist magazine (a favourite of Sarah Palin, along with Pravda, the Witchita Gazette and everything else printed since and by Gutenberg):

AAII
The retail investors as measured by the American Association of Individual Investor’s weekly sentiment survey are astonishingly pessimistic: 54% bearish.

To find a more gloomy view from the retail investor’s camp we’d have to go back to mid January when the AAII sentiment reached 59% bearish.

Back then I showed you this chart:

We have definitely seen 13 weeks pass since then and within a few more weeks will also complete 26 weeks. But unlike the historic average shown in the bar chart above, the market has yet to hold a decisive rally.

The S&P 500 Index (SPX) did momentarily reach a high of 1440 but couldn’t hold on to it. For most of the time we’ve been trading below the levels at which we first saw a +50% bearish AAII sentiment. As I’ve outlined before, sentiment during a bear market is a different beast.

Hulbert Newsletter Sentiment
Mark Hulbert is worried that while we may have put in a significant bottom with the March low, it may not hold. According to the Hulbert Stock Newsletter Sentiment Index (HSNSI) the average exposure recommended is a paltry 2.2%. And while this is low, back in early March the average newsletter editor was downright panicking with a -29.2% exposure - meaning actually being short the market with almost a third of total portfolio allocation.

As we head into a possible retest, it isn’t reassuring to see sentiment sitting so much above those levels. The ideal sentiment that would catapult us higher would be an even more intense panic with the kind of market weakness we’ve seen. While that may change anytime, the HSNSI doesn’t reflect that right now.

Investor’s Intelligence
No significant change in this sentiment measure: bullss dropped from 44.8% to 43% and bears increased slightly from 31.1% to 32.6%. It isn’t offering much of an edge as it sits in lukewarm waters similar to the Hulbert analysis.

CBOE Put Call Ratio
While the traditional put call ratio (equity only) did rise during the turmoil of this week, we didn’t see it reach or exceed the important 1.0 milestone. In fact, it only was able to muster a high of 0.84 on Wednesday. That reflects a good amount of fear but just not enough to carve out an important inflection point.

ISEE Sentiment
This past Wednesday and Thursday the ISEE Sentiment measure fell to 74 and 75 - the lowest since mid March low this measure reached 56 (March 10th 2008).

Remember, the ISEE sentiment numbers are calculated differently from the CBOE put call ratio. For one, the ratio is inverted with calls as the numerator and puts as the denominator. Further, the ISE only uses options which are traded by non-market makers, stripping out the noise and showing what retail and institutional traders are doing. And lastly, the ISE data is for opening orders only.

All in all, a much more robust and useful measure of options trading sentiment.

Rydex Traders
According to Jason Goepfert:

Rydex traders had finally started focusing on “safe” funds more than “risky” funds - a stark change from earlier in May when they were five times more likely to trade a risky fund than a safe one. As of yesterday, the ratio fell under 0.5, meaning that those folks were more than twice as likely to trade a safe fund than a risky one.

Conclusion
Since I eschew using a single indicator to light the way, the weight of the indicators are confusing with many cross currents pulling me in different directions. The troubling and somewhat muddy sentiment outlook doesn’t help. Hopefully things will resolve themselves soon and the picture will become clearer.

I took a few days off (hope you didn’t miss me too much). Let’s catch up by looking at the important sentiment developments:

ISE Sentiment
I mentioned the ISEE during last week’s sentiment overview when it increased slightly as the market fell, showing that retail option traders were seemingly not worried. Even more bizarre, during the past shortened trading week as the market staged a strong recovery, the ISEE value actually fell.

Part of the explanation for this aberrant behavior may be that I’m looking at the “All Securities” data for the ISEE, rather than the “Equities Only”. The latter measure showed no similar increase for the week of May 23rd.

CBOE Put Call Ratio
Again, in contrast to the ISEE’s behavior, the CBOE equities only put call ratio showed this past week that traders became more bullish as the market rose. Although not the ideal, this is the normal pattern.

The put call ratio fell to 0.59 - approaching levels of bullishness which have previously caused stock market rallies much difficulty.

Hulbert Newsletter Sentiment
According to Mark Hulbert, the Hulbert Stock Newsletter Sentiment Index (HSNSI) has almost doubled from +16.2% to +31.2%. And it did so from mid May to the end of May 2008. Although this is an significant increase, I don’t think it presents us with a situation commensurate with market top.

To give you an idea, during mid to late April 2006 the HSNSI reached +73.2% - when the S&P 500 index soon after fell from 1325 to 1225. And during the bear market bottom in October 2002, it fell below -60%. So all I can say from the current reading is that more newsletter editors are jumping into the bullish camp but still not enough to cause serious problems.

AAII
According to the American Association of Individual Investors’ sentiment survey, there are now 31% bulls, down 15% points from last week’s 46% bulls.

This is a welcome reprieve, especially as it is accompanied by a lower market. Had this key sentiment survey remained unchanged or actually increased in bullishness, the sentiment tone would be definitely different.

Investor’s Intelligence
Similar to the AAII survey, the II sentiment measure fell from 47% bullish to 37.9%. I was worried about this since last week’s number was almost 50%. The keepers of this measure, the editors of ChartCraft, Burke and Gray agree with my general take on the market’s sentiment:

“While the sentiment is moving away from a bullish reading it is not yet close to calling for a market top”

I continue to see a lot of long term positives for the market and continue to believe the March bottom to be a major one. What I suspect we are seeing is a (hopefully) shallow pull back or pause before the next leg up.

Magazine Cover Indicator
Uh oh. Anyone long crude oil or any traditional energy related equities should be worried.

The Economist isn’t the most widely read publication but their cover stories still do carry weight - in a contrary sense most of the time. The price of crude has already tapered off and I suspect this will be either a significant top or at minimum a longish pause.

There are, of course, other signs that the whole energy rally has run its course. There are several technical signs, including the increasingly sharp slope of the trendlines as well as ominous candlestick formations.

Here’s this week’s sentiment summary:

NASDAQ:NYSE Volume
I touched on the relative lack of volume and how this has historically marked tops, rather than spurred on rallies. Another troubling volume development is the ratio of volume on the Nasdaq compared to the NYSE. We are seeing a spike in this ratio, meaning that Nasdaq volume is significantly more than NYSE volume. Since the Nasdaq represents the riskier side of the market, this has usually meant that there is too much froth in the market.

Sentiment Surveys
Last week I pointed out the danger of having the AAII remain at 53% bullish when the market had gone down slightly. Although this week the AAII respondents were slightly less bullish (45%) it is good to see their excitement abate in the face of a week that saw the market go up.

This reversal however only slightly dilutes the contrarian bearish meaning of this indicator. We are still at a very high level of bullishness. Simply by receding from the extreme level of bullishness that we saw last week does not eliminate the topping signal that the AAII is giving us at this point. After all, it was in October 2007 when we last saw this sentiment measure at such heights.

Investor’s Intelligence, the measure of newsletter sentiment compiled by ChartCraft, showed little change going from 44.4% bullish to 46% bullish.

Hulbert Newsletter Sentiment Survey
In contrast to the sentiment surveys mentioned above, the Hulbert Stock Newsletter Sentiment Index is continuing to suggest that newsletter editor are still either skeptical of the market’s recovery or not really excited by it.

At the start of the week, the HSNSI was 16.2%, meaning that the average market timing newsletter was suggesting to their clients being long just 16.2% of their portfolio. This is much lower than the 27.5% which they were recommending in late April, even though at that time the market was lower than it is now.

Slicing and dicing the newsletters, Hulber finds that the stock market newsletters with the best track record of timing the market are continuing to be bullish, while those that have lagged buy and hold are much less so. This gap in sentiment and performance has, however, significantly diminished from mid-March - when the market hit its inflection point.

Is LowRisk Dead?
A reader already asked about the lack of updates from LowRisk. I emailed Jeff Walker, the keeper of the data and when or if I receive a reply I’ll write a follow up. The last update on their site is for March 23rd 2008. I haven’t received any email updates either - I’m subscribed. In any case, LowRisk was never one of the major sentiment surveys that I relied on. It was a bit too volatile and no one except Walker knew the size of the sample size.

Magazine Cover Indicator
Here’s an interesting magazine cover for analysis (below): “Barbarians at the vault”. It is the latest Economist cover showing a bank being besieged by a horde of angry “barbarians” carrying banners with such slogans as :

• Skin the fat cats!
• Just say no to CDOs
• Regulate now
• Salary limits

The building is on fire, there is a column being pulled and there are sledgehammers being taken to its pillars. Pretty powerful imagery. I wonder how it will play out with the Philadelphia Banking Index being where it is:

Check out the Economist’s “prowling bear” cover in 2006. As disclosure, I’m long the AMEX Financial Select Sector ETF (XLF).