Trader’s Narrative

Since we are considering whether this is a potential top, I thought a closer look at the ISE Sentiment data would be helpful. This is the options transactions on the ISE and it is predominately retail traders so it can help us to zero in on the more novice participants. Since the ETF and index options can skew things, I discarded them and only included the equity only data. Then I also charted a simple 10 day moving average to smooth out the daily volatility.

I featured a similar chart the Sentiment Overview for mid May but it didn’t have as much data as this one. We are getting up there, but not as high as before. The 10 day moving average of the ISEE Sentiment Index is 181. That’s the highest since January 2nd 2008 when it reached 186.9.

Also notice that the March 2009 stock market low doesn’t even register as a blip on the 10 day moving average.

I also looked at the ISE equity only data and focused on any 250 and above - meaning that for every 100 puts, 250 or more calls were bought on that day. Then I looked what the S&P 500’s return was going forward from that day for 1 month, 3 month and 6 month intervals. Here are the results:

There is a definite negative bias, but it isn’t overwhelming. If anything, the market is flat to mildly negative. But we haven’t seen such a wildly optimistic day in a long time. The last time was on October 29th, 2007. Also, notice that the 6 month negative returns start to pile up from June 2007 and onwards. Before that, things are basically flat.

To see the flip side (extreme lows) check out ISE Sentiment: A Closer Look - but note that the data for this includes all securities (equities, ETFs and indexes).

Here are this week’s sentiment cross currents:

Investors Intelligence
The measure of stock market newsletter editors sentiment published by ChartCraft shows 36.0% as bullish and as 37.2% bearish. This is a reversal of the previous two weeks where we had seen the bulls outnumber the bears. It is difficult to dismiss the rapid increase in bullishness we’ve seen since the March lows as a hallmark of bear market rallies since we’ve seen the same II pattern in previous new bull markets.

American Association of Individual Investors
The sentiment survey of retail investors shows a reduction in number that were unsure from 29% to 20%. The 9% increase in conviction was almost equally apportioned, with 36% bullish and 44% bearish.

Perhaps more meaningful is the asset allocation of the AAII. They have a paltry 41% of their portfolios dedicated to equities. This is the lowest in the history of the survey (going back to 1988). It is slightly lower than what we saw on previous long term market bottoms: early 1991 and late 2002. As well, to highlight the insecurity the average American retail investor is feeling, they have pushed their cash allocation all the way to 45%. Not only is this an all time high it is the first time that the size of cash in portfolios has trumped equities.

Hulbert Newsletter Sentiment
Since the March lows, the HSNSI has jumped by more than 45% points. While some increase in optimism is warranted in a new bull market, this much of an increase is atypical of the historical playbook. During the first 52 days of the average bull market since 1965, the stock newsletter editors that time the market have on average only increased their bullishness 29.3% points. You can read more about Mark Hulbert’s recent research into the pattern of sentiment in new bull markets. This was featured a few days ago at news.tradersnarrative.com where you can find a continuous stream of interesting articles.

Option Sentiment
Nothing really new in this area, see previous week’s sentiment overview for further details. That discussion is still valid.

Sell In May And Go Away
You know the old Wall St. adage, “Sell in May and go away”. Well, here we are. We have now officially entered the time period which has historically been most difficult for the stock market.

So far we’ve had a tremendous rally off the March lows: the S&P 500 index gained 28.4% and for the two months of March and April, it has risen 25% with most of it coming from March. April’s gain was 8.2%

Looking at market cycles, this is rare. To see such a similar strong performance for the months of March and April we would have to go back to the 1930’s where intense bear market rallies were the norm. In those times, it wasn’t a good time to put fresh money to work (hence the label of bear market rallies and the annual cyclical nature of returns).

Big Money Poll
Last weekend brought out Barron’s quarterly Big Money poll. The small group of strategists surveyed were decidedly optimistic with 59% stating they were either bullish or very bullish. While a surprising 58% stated that they didn’t believe the market had bottomed yet, almost the same percentage (59%) identified the stock market as the best asset class for the next 6 to 12 months going forward. I’ll leave you to ponder the riddle of their logic.

The problem with the Big Money poll is that in its history, as a group, it has never been truly bearish. So while we would like to use it as a contrarian measure, we really can’t because for the most part it has no edge.

Drilling down into the sectors, the most unloved were Transportation and Utilities. In contrast, the Big Money poll liked corporate bonds, emerging markets (Latin America & Asia) and oil. But the one thing they almost all agreed on (84%) was to be bearish on US treasuries. This is puzzling since they’ve been persistently bearish on bonds for the past 8 years in the face of a powerful bull market in that asset class - especially in 2008.

Wall St. Strategists
The insistent bearish stance of the Big Money poll participants is in contrast to the current recommended allocation by the average Wall St. strategist. Right now they’ve peaked at a suggestion of 38.9% of client portfolios to (US long term) bonds, which is the highest in 12+ years. The last time they were even close to this level was in 1998 (34% allocation) when bonds topped and didn’t regain their previous high for another 3 years.

The asset class garnering the highest allocation is equities with a 52% weighing. Similar to the Big Money poll, Wall St. strategists are never outright bearish. Their bullishness is either raging or reluctant. So put in that proper context, the current allocation is very timid. It is the lowest allocation to equities since 1997. And during the bear market bottom of 2002-2003, their equity allocation was 68%.

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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.”

Here is the summary of sentiment data for this past week:

Earnings Season
We are about to enter the heaviest weeks of earnings season, with some nasty surprises, so buckle up!

Sentiment Surveys
The weekly AAII sentiment survey reflects 36% as bears (a decline of -8% points from last week) and 44% bulls (a rise of 8% points). Not surprisingly, the rally is continuing to send positive ripples through retail traders.

ChartCraft’s Investors Intelligence survey of stock newsletter editors this week shows the most bullish posture since the start of this bear market (that is, assuming we’re still in it). With this week’s results, the optimists outnumber the pessimists for the the first time since January 2nd, 2009. Previous to that, it was in mid August 2008 and before that, a period of time from mid April to June 2008. All of those times coincide with market tops.

According to the Hulbert Stock Newsletter Sentiment Index (HSNSI), which measures sentiment among short-term market timing newsletter editors, while the market has spent the past 2 weeks treading water, newsletter editors are much more bullish. Two weeks ago they were suggesting to their readers an average long position of only 8.8% but now, that’s jumped almost 18% points to 26.5%. It isn’t the nominal value of the sentiment but the fact that there has been a remarkable increase in bullishness with no real market movement to provide a rational cause for it.

NFIB
It wasn’t that long ago when the National Federation of Independent Business (NFIB) Small Business Optimism Index fell to a new low. In April it once again set a record, falling to 81. Small businesses across America are continuing to retrench - no green shoots in sight!

Option Sentiment
Earlier in the week I outlined how the option traders are pushing their luck. Follow that link to get more details. During the rest of the week they continued to press their luck. The ISE sentiment index, tracking the retail options trader spent 3 consecutive days above 200 - meaning that they bought twice as many calls to open a trade as puts this week. The last time that we saw this many consecutive days of bullishness was in late December 2007 when the S&P 500 was trading at ~1475. The last time before that when the ISE sentiment index hovered over the 200 level for 3 or more consecutive days was in late October 2007 - when the market had just begun this brutal bear market. With odds like that, the rally is on very weak legs.

In confirmation, the CBOE put call ratio continues to hover around the mid-point (equity only data). This ratio ended the week at 0.56 - meaning that the option traders were buying almost twice as many calls to puts.

Fund Flows
Similar to the twitchy Rydex market timers, who are all of a sudden very bullish now, the typical US equity mutual fund buyer has finally returned to the market. Early fund flow data for the short term, weekly data, indicates that we are seeing tentative but clearly net positive inflows into US equity mutual funds. Of course, we can’t play a contrarian at all times. The stock market needs this capital injection - especially considering the gargantuan amount of scared money sitting on the sideline. But in the past, whenever these market participants have peeked out from under their covers and dared to re-enter the market, they’ve had their head handed to them. The most recent example was the new year top (January 2009).

NAAIM Survey
Although it slipped mention, the National Association of Active Investment Managers (NAAIM) sentiment survey was an emaciated 2.15 on March 4th, 2009, just days before the launch of this latest rally. Although I didn’t mention it at the time, I’m not sure if it is meaningful because in the short history of this sentiment indicator, there are two weeks with a more bearish outlook: July 9th, 2008 (2.03) and October 8th, 2008 (-2.97) and neither of them really resulted in much of a rally. In July, the S&P 500 went sideways and eventually wilted and in October the market thrashed about but quickly melted even lower. While I continue to monitor lesser known indicators like the AAIM, I’m not totally convinced that it has proven itself to deserve our full attention.

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I’ve been sounding off a cautionary note as action in the equities market appears top heavy. But today it became obvious that the option traders are starting to really push their luck:

Although it is just one data point, having so much call buying that it pushes the ratio to double the number of calls to puts is rare. The last time the CBOE put call ratio was trading at 0.50 or lower was in December 2007 when the S&P 500 was at ~1500. You can see a more long term chart of the put call ratio in the above link.

And it isn’t just the option traders on the CBOE. The equity only ISEE sentiment index - which specifically measures retail option traders - came in at 203 today. That means 203 calls were bought to open a trade compared to 100 puts bought to open a trade. The last time this ratio was above 200 was December 30th, 2008 - just before the market took one too many sips of the bubbly and had the New Year’s tumble.

I’m a bit hesitant because there have been some data integrity issues with the ISE before. So to make 100% sure, I’ve contacted them to confirm the most recent number. If there is a change, I’ll write about it. Otherwise, the number stands.

If you’re new to this new method of looking at retail option traders, then this is a good introduction to the ISEE sentiment index.