Trader’s Narrative

Here’s this weeks’ sentiment overview:

Sentiment Surveys
According to ChartCraft’s Investors Intelligence survey, 40.4% of newsletter editors are bullish, while 31.5% are bearish. This ratio of bulls to bears takes us back to where we were in mid April 2009.

The US retail investor, as measured by the weekly AAII survey, has recovered quite well from the shell shocked state we found them in in early March 2009. In that sentiment overview, the AAII put in a new record bearish extreme with 70% expecting further declines in the stock market. Since then, they have recovered 37% points - that’s more than half.

So this week we are seeing a similar sentiment picture from the AAII survey: 44% bullish and 33% bearish. Check the link to see the only two other times in the history of this metric that we had seen such an extremely gloomy outlook from retail investors.

And finally, the AAII equity allocation jumped from 41% to 50% of portfolios. Most of this increase is coming from a reduction in cash holdings. While this may seem negative, it is required. Unless investors allocate more capital to equities, how can it appreciate? At the same time, the current allocation is still historically low; equal to late 2002 and early 2003, as well as early 1991 - all great times to jump back into the market.

Options Sentiment
The short term moving average of the CBOE put call ratio is about as low as in May 2008 - which was just before the market rolled over again and cascaded down into the November 2008 lows.

The ISE Sentiment is also showing similar levels of complacency. Today’s ratio was 191 - meaning that calls were purchases almost twice as much as puts. (not show on the chart below). That’s a little bit lower than the 225 call to put ratio from this Tuesday:

The previous high in this ratio occurred on December 30th 2008 (234) when the Santa Claus rally hit the wall. But notice that the high call buying cluster in mid April didn’t seem to faze the market in the least. The options market remains the one sentiment measure that has been strangely affected during this bear market. Maybe I’m not reading it correctly or maybe something structural has shifted. Either way, I’m growing wary of giving too much weight to it.

Volatility
After falling to a 6 month low in mid April, the CBOE Volatility Index (VIX) continues to drip lower. It is now below both its long term (200 day) and medium term (50 day) moving averages. As I pointed out before, while the VIX has been acting lethargic in comparison to the sprightly S&P 500, it seems to be begrudgingly confirming the rally.

While the VIX is saying that the market volatility is lower now than before, it doesn’t really feel that way to those that watch the tape every day. That’s because the market is just as volatile. As Mark Hulbert points out, if we count the number of days in which the market has risen or fallen 1% or more, it becomes apparent that we’ve seen as many of these ‘volatile’ days now as before when the VIX was almost three times as high.

Insider Activity
As mentioned before in a previous sentiment overview from a few weeks back, corporate insiders have started selling their company’s shares at a rapid pace. It is hard to believe but they’ve picked up the pace since then and pushed the ratio of sales to buys to a fresh highs.

Fund Flows
There is a change in the air. Investors are venturing out of their bunkers and taking on some risk. Equity mutual fund flows is now at a rate to be $8 billion for the month of May. While this may appear to be bad news, from a contrarian point of view, we have to keep in mind that any sustainable rally in the market requires fresh funds to fuel it.

As well US junk bond funds saw an $822 million inflow this week. So not only are investors taking on the kind of risk that comes with equity ownership, they are suddenly showing a very healthy appetite for the much more riskier asset class of junk bonds.

The Grey Beards
Once in a while I like to check in with the Grey Beards, the investment professionals that have seen more market action than most of us. Right now, they are for the most part bullish. Doug Kass of Seabreeze Partners, Jeremy Grantham of GMO and Richard Russell of Dow Theory Letters. Each of them has acknowledged that we are transitioning out of a bear market into a bull market. Some of them, like Russell, very grudgingly. By the way, I recently added Grantham’s latest client letter to the Free Trading Resource section (under Reports & Articles).

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Here is a concise summary of this week’s sentiment data:

Sentiment Surveys
For weeks now I’ve been pointing out that the really interesting scenario would be if we saw the market rally while bullish sentiment decreased (or inversely bearish sentiment increased). That is what contrarians look for because it signals that people are not really believers in the rally. This is a tricky concept because while a prolonged bull market requires wholesale participation by buyers, it is frustratingly difficult to recover from a bear market if everyone thinks that every single blip is the start of a full blown recovery.

ChartCraft’s Investors Intelligence weekly survey of newsletter editors showed a decrease in optimism for the first time since the start of this rally. The bullish side fell 4.1% points to 39.1% while the bears came in at 34.5% - almost unchanged from last week.

The AAII weekly survey of retail investor sentiment shows a similar picture. There was a 3% point increase in the pessimist camp with the bears at 39%. Meanwhile the bullish camp fell significantly - 12% points - from last week to 32%.

Option Sentiment
While it spent the whole week lower, the ISE Sentiment index jumped to 171 (equities only). This means that the retail trader bought 171 calls to open compared to 100 puts. While it is just one day’s data, it definitely shows that optimism is easily stoked.

In contrast, the short term moving average of the CBOE (equity only) put call ratio is still quite low, corresponding to market tops. If we adjust for the upward sloping range of the data we find it at a similar level to October 2007:

Insider Activity
The similarities to October 2007 just keep coming. From the Nasdaq Bullish Percent Index, to the above mentioned put call ratio. Now insiders are getting in on the act. According to Washington Services, that tracks such activity, corporate insiders are taking advantage of this rally to cash in. For the 3 weeks so far in April, insiders have sold $8.32 for every $1 they have bought of their company’s shares. The last time they were in a similar dash to sell was (you guessed it) October 2007.

What is even more alarming is that we are seeing the lowest amount of outright buying from insiders for the past 17 years. Since insiders are considered the “smart” players in the market, they obviously wouldn’t act this way if they believed that the worst was behind us.

Magazine Cover
The Economist’s cover for this week asks: “A Glimmer of Hope?”. While acknowledging the mood of acquiescence to the ‘recovery’, it outlines the disadvantage in believing that everything is fine now: The world economy and the perils of optimism:

“Welcome to an era of diminished expectations and continuing dangers; a world where policymakers must steer between the imminent threat of deflation while countering investors’ (reasonable) fears that swelling public debts and massive monetary easing could eventually lead to high inflation; an uncharted world where government borrowing reaches a scale not seen since the second world war, when capital controls ensured that savings stayed at home.”

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Investors Intelligence
On Tuesday, just as the market was poised for its rocket ride higher, ChartCraft’s Investors Intelligence survey of stock newsletter editor’s sentiment showed 26.4% leaning bullish and 47.2% bearish. That’s a pretty good level of pessimism but not nearly as much as we saw late last year when bearish respondents came in at around 55%. It will be interesting to watch next week’s numbers to see if there is a continued collapse in hope or whether the market’s recent bounce causes people to jump on the bandwagon again (as they have repeatedly during this bear market).

AAII
After last week’s historic AAII sentiment survey results, it isn’t surprising to see some push back. The bearish camp shrunk by 15% points to 55%. That’s still very high but no contrarian likes to see such a the sudden move in response to the rally we saw. The optimists rose 9 percentage points higher from last week to 28%. The survey was taken on March 12th, after Tuesday’s massive one day rally. Real capitulation would have been either a more timid move towards optimism or continued slide into further pessimism.

Options Sentiment
The options market continues to behave very strangely. After the spike high in the ISE sentiment, that option ratio calmed down a bit but it is still showing an elevated level of call purchases (compared to puts).

The CBOE (equity only) put call ratio concurs with a very low reading for the whole week. The averages (10 and 50 simple day moving average) are both stuck in the middle, not providing any real signal.

OTC Volume
One measure of investor optimism is the activity in the “over the counter” market. Since it has less regulation and oversight, as well as smaller, riskier securities, it is a good barometer of investor sentiment. In the past, extremes of activity in the OTC market have marked the “blow off” stage. In a hurricane even turkeys can fly and in a bull market, the highest flyers are often the lowest quality OTC stocks. Right now the level of activity in the OTC market is extremely low. Lower than the 2002-2003 bear market low, lower than the 1998 crisis low. The lowest in at least a decade, in fact. If OTC activity had an EKG, it would have flat-lined. Which is good in a sense because it shows that we have wrung out every single drop of excessive speculative energy (at least in this corner of the market).

Insider Buying
Corporate insiders continue to pour money into their own companies stocks with renewed vigor. We are now approaching the level of buying frenzy that we last saw in late November 2008. Although these are generally viewed as the “smart money” crowd, over this bear market, they have not shown the usual agility in timing the bottom. If the market continues to rally, they will have finally been proven right.

Mutual Fund Cash
The cash buildup in mutual fund portfolios continues. The estimate now is that almost 6% of the average equity mutual fund portfolio is made up of cash or equivalents. We need to “normalize” that to take into account different monetary conditions over time (see previous mention for more info).

We are now approaching the equivalent of the mid-1990’s for normalized cash holdings. This isn’t the extreme that we saw, for example, in the mid 1970’s or the early 1990’s. Both of those times coincide with a massive buildup of cash and a lasting market bottom. However, today’s level is enough to stoke a bull market - assuming the other ingredients are also there.

This could be caused by the general pessimism pervading Wall Street right now. And it could also be that the average fund manager’s hand is forced by the unforgiving onslaught of mutual fund redemptions. The fund flow data certainly shows that the average retail mutual fund owner has had enough and is cashing in (possibly at the bottom or close to it).

Magazine Cover
This week’s magazine cover indicator comes courtesy of The Economist:

The two major groups in the stock market have been and will always continue to be large, well capitalized and well informed “insiders”; and the small, underfunded, emotional, ignorant retail investors and traders.

These two groups engage in a financial dance which invariably concludes in the long term with one group enriching the second. Although they usually don’t take such contrasting positions, at times they can mirror each other.

A good example was in 2000 at the top of the internet bubble. The knowledgeable, “insider” team made up of hedge funds, investment banks, other Wall St. operators and the private equity team sold bits of paper (shares) in exchange for money from the retail crowd.

Right now we are seeing another one of those times. But this time it is the “insider” team that is on a buying spree.

Commitment of Traders
I’ve already mentioned that the commercials were crazy long equity futures contracts and although some time has passed things have not changed. The commercials are long about $38 billion worth of contracts while the small speculators are long their smallest amount since the bottom of the bear market.

Fund flows
According to fund flows data estimates, as the retail investor is fleeing the equity markets and seeking the sanctuary of bond markets and money market funds, the institutional investor is buying with the same intensity. Watch video about half way on the link.

Insider Activity
Corporate executives and other insiders are probably the most knowledgeable about a company’s future and while the market has taken a tumble, they haven’t been spooked. On the contrary, their buying here is only equaled to that seen at the bottom of the bear market. This in contrast to the retail investor who has been buying anything but US equities.

Newsletter Market Timers
The best market timers among the newsletters are wildly bullish, with an equity allocation of 92%. Meanwhile the worst are out of the market completely with a 0% allocation.
Credit: Mark Hulbert in Barron’s

Insider activity is a reliable metric which I haven’t discussed in a while. It is a bit quirky because by nature, insiders are net sellers. They get allocated shares as a pay package or through option incentives and they usually turn around and sell.

It is also natural for them to sell in a rising market. So in a bull market, seeing a rise in insider selling isn’t necessarily a harbinger of doom. In contrast though, insiders can tell us a lot more during market declines - like the one we’ve been having lately.

If insiders continue to sell or increase the pace as the market falls, this is a very negative tell for the market. In effect, the insiders are saying that things are probably going to get worse (so they want out now).

But if insiders start to buy during a down turn that has strong bullish interpretations. Although, when I say buy, what I mean in effect is sell less than the usual.

By comparing the buys and sells, we can track the relative sentiment of insiders. Last summer, just as the market was about to make a bottom, the ratio of insider sells to buys fell to 2. That is a very low number and it basically means that on average for every 2 shares sold, one is bought.

Remarkably, just as the market was peering into the abyss in mid August, according to Vickers Weekly Insider Report, the sell to buy ratio fell to an incredible 0.92!! This meant that there were actually slightly more shares bought than sold.

Since insiders are by nature net sellers, this is a very rare occurrence. The implications it has for the market are unmistakeably bullish.

Consider this other tidbit: the last time the ratio fell to less than 1 was in late 2002, marking with uncanny precision the end of the bear market.

I find it remarkable to see the market just below all time highs with such positive insider sentiment. The bull market doesn’t seem to care that it is long in the tooth, doesn’t seem to care about the sub-prime mess, or any other “logical” reason why it should not go higher and higher.