Trader’s Narrative

Here’s the sentiment summary for this week’s trading:

Sentiment Surveys
According to the sentiment surveys, an alarming number of investors and market timers have returned to the long side. The weekly AAII retail investor sentiment survey shows 48% bulls (an increase of 8% points) and 37% bears (a decrease of 12% points). We haven’t seen this many bulls in the AAII survey since the first week of the year. As I’m sure you’ll recall, that was not a happy time for putting new money to work on the long side.

According to ChartCraft, the weekly Investors Intelligence newsletter sentiment survey shows 42.5% bulls and 25.3% bears. The S&P 500 ended the week 21 points higher (or 2.2%) so the market hasn’t really done anything to deserve such hope or devotion.

Barclays Capital Sentiment Survey
Barclays Capital said that only 17.5% of the 605 respondents to its quarterly sentiment survey believe that ‘risky assets’ have more room to rise. Those taking part in the survey were central banks, asset managers and hedge funds. The majority believe that the world economy will experience either a protracted slowdown or if it is in recovery now, it will falter once more (a “W” shaped recovery). Asked whether the spring rally was just a “bear market rally”, 60% agreed - indicating that there is still a lot of dry powder out there.

NAAIM
Along with most sentiment measures the NAAIM trend survey of managers has recovered since the spring lows. For more information on the metric check out: NAAIM Sentiment Survey.

Market Froth
We’ve seen a lightning fast return of speculative trading to the stock market. You can see it in the volume of ‘garbage’ stocks (trading below $5/share) and in the general willingness of most people to shrug off the dark foreboding sense they harbored just a few months ago that the end was nigh.

There is also mounting evidence from the Rydex fund flows that the trigger happy traders that use these securities to time the market are piling into the long side. This is the case for both leveraged and normal Rydex funds and has in the past marked either significant market tops or the start of a plateau. In either case, when there is so much lopsided optimism in Rydex mutual funds, it is a flashing red light for those long the market.

Magazine Cover
I have a gut feeling that this week’s Economist magazine cover should be framed somewhere for posterity. It is a graphic showing a Tyrannosaurus Rex made up of car parts, leaking oil (as if bleeding).

I can’t help but wonder, if by the time a magazine puts up something like this, have the auto industry sector reached a nadir?

And I’m not thinking that because the image is hyperbole but because it is a creative representation of the unvarnished truth. I’d prefer if it was on Newsweek or Time but we’ll see. I think this Economist cover is one we’ll come back to years from now.

Here’s this week’s sentiment landscape:

AAII
The retail investment survey carried out by the AAII is almost unchanged since last week with 44% bulls and 35% bears.

Investors Intelligence
ChartCraft’s survey of newsletter editors’ sentiment showed 41% bulls and 33.7% bears. Similar to the AAII survey, very little changed from last week. If anything, the undecided’s shrank.

Options Sentiment
The CBOE (equity only) put call ratio closed the week, very close to where it started it, at 0.63. Looking at a short term moving average, we’ve reached a level that has previously corresponded to market headwinds. The CBOE put call ratio has a slight upward slope, so the ‘low’ keeps shuffling higher. We are now back to levels which we last saw towards the end of March 2009 - of course, that didn’t stop the market from marching higher.

While the S&P 500 has been in a downtrend for the whole week, hitting a high of 920 and then closing at 883, you wouldn’t know that if you looked at the ISE Sentiment Index. Retail option traders, as measured by the ISE. On Monday and Thursday they bought almost twice as many calls as puts. That’s befuddling so let’s step back.

This chart shows the equity only ISE Sentiment index from January 2008 till now. Looking at the 10 day moving average of the ISE Sentiment, we can see that it is now at levels that correspond to past market tops :

Since 2008, whenever the ISE ratio reached 180 or so, stock market prices fell. The first case was in early January 2008 when the ratio reached 183. The second was May 2008 (174), which was the top of the first real bear market rally. The third was in the final days of 2008 when the Santa Claus rally petered out (173.5). And that brings us to today with the 10 day moving average of the equity only ISE sentiment ratio at 180.

Having said that, the ISE Sentiment’s 10 day moving average has gone much higher. On July and October 2007 it was 245 and 229. But the psychological tone of the market has changed from that time and it is more useful to look at the behavior of this indicator during the bear market.

Finally, notice that this options sentiment measure totally missed the March 2009 low - no indicator is perfect. This is why I look at the weight of the evidence rather than singling out any specific metric at any point in time.

Bloomberg Professional Global Confidence Survey
I mentioned this relatively new sentiment a few days ago at news.tradersnarrative.com. Since it was only started in November 2007, we have scant information for comparison but according to the participants, the global economy is on the mend. The BPGC climbed to 38.72 in May from 21.2 in April. That’s the biggest increase since the start of the survey. But because it is still below 50, it means that they view the economy as still contracting (but just not as much).

Also, for the first time since the start of the survey, investors are predicting that the Standard & Poor’s 500 Index will climb higher.

The respondents were most optimistic about Brazil and Mexico - shrugging off any lingering swine flu panic. And less enthusiastic about European market forecasting that France’s CAC 40, Germany’s DAX, the IBEX 35 in Spain and the U.K.’s FTSE 100 will decline.

Brazilian confidence climbed 11 percent to 62.6 - its highest level since June. As I mentioned a few days ago the Bovespa has been on a rampage posting the biggest monthly gain in four years in April 2009. The obvious explanation is that investors are betting lower interest rates and firming in commodity prices will propel their market higher.

Here’s this past week’s sentiment wrap-up:

Investors Intelligence
ChartCraft’s famous sentiment indicator, measuring newsletter editor’s mood shows 31% optimistic and 38% pessimistic. So the slow, rebuilding of confidence continues with a gradual growth of the bullish camp. However, we did see, what has to be considered real bearishness. For example, consider that back during the end of the previous bear market (2002-2003) the II bullishness ranged from 40%-30%. And during this bear market we’ve see it in the 20’s for a few weeks. The question is, how comparable is this market to “normal” bear markets we’ve seen before?

AAII Sentiment
This week’s survey of retail investors shows a slight reduction in bears to 37% and an almost proportionally equal increase in bulls to 43%. This is natural considering the market moves we’ve seen but we are now once again in “no man’s land”, having quickly resolved the extreme pessimistic sentiment reading in February 2009. Contrarians are interested in not only extremes of sentiment but also divergences and while we saw the first, the second is missing so far.

AAII Asset Allocation
Although not as famous as the weekly sentiment survey mentioned above, the AAII folks keep track of another sentiment metric: how their members allocate assets between cash, bonds and equity. As you can imagine, moments of extreme are contrarian signals. For example, in early 2000, AAII respondents had on average a paltry 12% allocated to cash with the bulk of their portfolio (77%) in equities. We know how that story ended.

The last time we went over this metric was in a mid-February sentiment overview when the AAII asset allocation had skewed heavily towards bonds, reaching a decade plus high. Since then bond allocation has been reduced from 24% to 14% (I guess they beat a quick retreat when the bond market didn’t cooperate).

But more interestingly, the cash allocation is now 45% - an all time high!

And equity allocation is down to only 41% - an all time low!

As if we needed any further confirmation that what we are living through these days is a market of epic proportions. But there it is. The AAII equity allocation is now lower than at any time since the data - going back to 1988 - started to be collected.

Consumer Confidence
After reaching historic lows (again) in February, the Conference Board’s Consumer Confidence index inched higher in March (going from 25.3 to 26). For the most part you could argue that not much has changed from the perspective of US consumers. Most of the tiny uptick can be attributed to the Expectations index which measures consumer sentiment towards the future - it was up 1.6%:

We are still seeing generational lows in consumer confidence. This index was started in 1967 but the lowest handle it had ever had was 40 - until late last year when we made history (and continue to do so). The previous historic low was in 1974 during the dark days of that bear market and the next lowest was in early 1992. So it won’t surprise you that, within a long term view of the market, depressed consumer sentiment is one of many conditions necessary for a new bull market.

Here is the sentiment wrap-up for this short but exhilarating trading week:

AAII
As I briefly mentioned yesterday, the weekly AAII sentiment survey shifted significantly. Optimists fell to 22% (a fall of 11% points) and pessimists weighed in at 57% of respondents - an increase of 18% points from last week. While this is a welcome from a contrarian perspective, it isn’t the lowest or even one of the lowest ratios we’ve seen historically.

Investors Intelligence
In contrast, according to ChartCraft, the editors for stock newsletters continued to shift restlessly, increasing a tiny amount in bearishness to 41.1% (and a small decrease in bullishness 31.1%). Not very helpful.

ISEE Options Sentiment
When the market broke the January lows on Tuesday (February 17th, 2009) and looked like it might not just approach but break through the November 2008 Maginot line, you’d imagine that the majority would be drenched in fear and grabbing all the puts they could get their hands on. But judging from the ISEE index, small time option traders are nonchalant about any such potential danger.

Take a look at the equity only ISEE data for the past few months (the higher the ratio, the more optimism it reflects):

Not only have they been buying more calls than puts (to open trades) during the harrowing but short trading week, this ratio actually went up on Tuesday’s wide range decline. The only consolation is that such puzzling behavior is par for the course, as option trading data has been continually befuddling during this bear market.

CBOE Put Call Ratio
The more traditional CBOE put call ratio (equities only) spiked yet again above 1.0 - but we’ve been here before. It does, however, dove-tails nicely with the OEX put call ratio which I mentioned last week.

StateStreet Confidence Index
This lesser known sentiment indicator reached its low late last year - reflecting the dire straits that managers found difficult to deny after the spike down in October and November. Since then the regional data for North America has more than doubled from 30.6 to 64.5. And the global confidence index has recovered from its ‘all time’ low of 48.2 to reach 72.9 - which would imply that the average money manager out there is now back at the risk buffet. But remember that since the StateStreet confidence index is still a relatively new indicator, the best prescription is to take it with a truckload of salt.

Volatility
While the market is once again at the knife’s edge, the VIX volatility index is surprisingly low. While it did gap up on Tuesday, the VIX is still meandering around the 50 level - far from the 80 double peak in October-November 2008. This is less a separate confirmation of any sort and more a corollary of the crazy options market we’re seeing.

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.