Trader’s Narrative

The Dow Jones was in fine summer condition putting in the best July performance since 1989 and its best month since 2002. Are we in thin air territory yet? To find out, check out the sentiment summary for this past week:

AAII
After 6 weeks of the bears continuously trouncing the bulls in the AAII weekly sentiment poll - something we hadn’t seen since the low in March earlier this year! - the bulls are back. The most recent survey of retail investors shows that optimists rose 10% points to reach 48% and the bears fell 11% points to just 31%.

We need the retail investor to return to the stock market for there to be a real and prolonged recovery. But such a jump in sentiment is troubling. Previously it has not supported higher prices going forward.

Investors Intelligence
The percentage of bulls jumped to 42.4% and the bears decline to 31.1%. So we continue to see a healthy amount of optimism from the average stock newsletter editor, although not excessively so. And this week’s numbers take us back to where Investors Intelligence sentiment was at the beginning of this month - when the S&P 500 was trading some 110 points lower.

Money Market Cash Levels
Believe it or not, there is more than $3 trillion sloshing around in money market funds. But the nominal amount of funds isn’t really that helpful to us since just like GDP it continues to grow along with the economy. What is helpful in determining where we are in the big scheme of things is the movement between equity markets and money markets.

Obviously when investors are fearful, they sell anything and everything ‘risky’ and put their money in the protective but less lucrative vehicle of money market funds. That’s exactly what we saw in March of this year: Tsunami Of Cash Just Waiting To Be Invested. Unbelievably, the total assets of money market funds was higher than equity funds!

That has now returned to its normal historic ratio with total money market funds decreasing to just $3 trillion. But it isn’t only the return to the historical pattern that is noteworthy. What we’re seeing is not an orderly and mild shower of liquidity but a veritable tsunami as both retail and institutional investors move massive amounts of assets from cash. Not only are they moving record shattering amounts, they are doing so in just one month’s time. So whether this recent rally is the real thing or not, large and small players are reacting to it with the reflexes of a cobra.

While this may be interpreted as very bearish, you have to note that not every single dollar taken out of money market funds is automatically put in the equity market. In fact, only a small portion is destined there. Had every single dollar been invested in the stock market by the way, we would probably bee looking at the S&P 500 at least 30% higher from where it is. The rational take away from this measure then is that the participants in the financial markets are recovering from the shell shock they suffered earlier this year and late last year.

Option Traders
Yesterday when we briefly broke above 990 on the S&P 500 index, the CBOE put call ratio (equity only) hit 0.50 - that magically half point marker is significant because it shows the average option trader’s raucous disregard for risk as they reach for the long side. Historically, it takes the market a few days to digest this before reacting lower. However, the last time the put call ratio plumbed these depths was in mid-April, earlier this year. And it was totally ignored by the market on its merry way higher.

On Wednesday (July 27th 2009) the ISE sentiment index (equity only) reached 220. That’s the highest level since June 15, just before it started a protracted decline from the June swing highs. As well, we’ve seen several days of higher ISEE data so the 10 day moving average that I track has inched higher as well. The last time the short term moving average was around 170 was in early June, just as the market ran out of steam.

Rydex Market Timers
Traders in the Rydex family of mutual funds have once again reached for the stars. These are fast, market timers who switch between the Nova/Ursa (bull/bear) funds to make money on either side of the market. As a group, they are a good contrarian indicator when they reach an extreme. As they have now.

The last time they caused us to mind their positions was back in mid June 2009 when they had a herded into a bullishly lopsided extreme.

Insiders Selling
Corporate insiders are once again selling their own company’s shares at a pace that is alarming. According to Vickers Weekly Insider Report, more than 4 shares are being sold now for every 1 share bought by an insider. To find a higher ratio we need to go back to October 2007. While this may appear to be a bright, red blinking light, there’s more reason to treat it as a cautionary yellow.

That’s because insiders, for all their reputation, do not have such a great track record in timing their own shares. They obviously do have an edge on others but they aren’t perfect and certainly can be wrong. But more often than not, they are right but tend to act too early - by about a year.

Here is this week’s sentiment summary:

Insider Selling
The bad news is that according to Argus Research, insiders selling pressure is now double what it was during the bottom in March. The good news is that it is still low enough to mean that insiders do not view the ensuing bounce as just a bear market rally. That gives you an idea of just how critical the March 2008 bottom was!

In mid-March, just as the market was trying to find footing, the sell to buy ratio hit 1:1. This is very rare since the long term average is just a tad above 2:1, meaning on a given week insiders sell 2 times as many shares as they buy. The last time this ratio was lower was in October 2002 when it reached 0.89:1.

Even better news, according to new research the “normal” level of selling to buying has been reset much higher due to the increasing allocation of ESOP as compensation for executives. Check out the book by Prof. Nejat Seyhun (University of Michigan) “Investment Intelligence from Insider Trading” for more.

Sentiment Surveys
There were no significant changes in the usual sentiment surveys I follow, namely AAII and Investor’s Intelligence, as bulls continue to outnumber the bears.

Investor’s Intelligence had 47.3% bulls and 30.8% bears while AAII had a similarly slight increase from 45% bulls to 46%. While optimism has the majority it isn’t anywhere near levels correspondent with major market tops.

ISEE Sentiment
This is rather odd. Usually when the market receives the kind of drubbing it got this week, option traders hurry to buy downside protection. But the reverse happened according to the ISE options data. The All Securities ISEE Sentiment Index actually went up from 117 to 140 on Friday.

This means that there were 140 calls bought (to open) for every put on the ISE platform. This isn’t the highest levels of optimism by any means. On October 8th it reached 187 and October 29th 192. But it isn’t just the absolute level of call to put buying that surprises me, it is the fact that it follows on a really bad week for the markets.

I’ve been cautious since mid April as indicator after indicator lined up against a strong continued rally. That caution seems to have been warranted as we’ve given up all the gains since. This latest ISEE data point is just one more that should keep any contrarian on guard.

CBOE Equity Only Put Call Ratio
In contrast to the ISEE Sentiment data, the CBOE equities only put call ratio went up during the week. Since it is the inverse with calls being the denominator of the ratio, this means that option traders, as measured by the CBOE became actually more cautious as the market fell.