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).

While I was focused more on the shorter term technical wedge formation, I paid less attention the the more important downtrend line that is barreling down on price. Watch this video from INO.tv to follow along with this important analysis:

After today’s decline, we’ve broken to the downside, out of the lower trend line. Of course this could be a head fake but I don’t think so. Pretty every single measure of breadth, sentiment and technical indicator out there has been flashing a sell for a few weeks as the market ignored it and kept going up. It seems gravity finally caught up with price.

I don’t want to go over the many indicators we’ve already covered in the past few weeks so I’ll just briefly cover two. The first, the percentage of S&P 500 components that closed above their 50 day moving average has been not only extremely high, it has uncharacteristically stayed there for the past 30 days of trading. Today’s declines pushed it down from almost 90%.

Another specific indicator, the ISEE Sentiment index has been elevated sporadically since May 5th when it reached 225. Then on Friday (May 8th) it was 191 and on Monday 197. And more alarming, on a down day like today, when the S&P 500 and the Nasdaq ~3%, the ISEE was 179. That means even when we have a clear down trending day, retail option traders are still bullish enough to buy 179 calls for every 100 puts.

What we’ve been asking ourselves is whether this is a bear market rally or a nascent bull market. This is far more than a technical question to be answered for bragging rights. Fact is that distinguishing between the two allows us to calibrate the indicators that we look at. As I’ve mentioned before, breadth measures and sentiment act very differently during a bear market than during a new bull market.

For obvious reasons, there are precious few tools that this kind of guidance. The Coppock Curve, although not perfect, is one of them and by the end of the month we’ll have a better idea. For more information on this indicator, check out the previous link. The “line in the sand” is the 874 level for the S&P 500 index. If we can hold that by month’s end, even if we head lower, the Coppock Guide will have provided a signal.

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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.”

According to the talking heads the US stock market declined because of worries related to the “stress test” and due to the bad news from Bank of America (BAC). While these are valid events, they aren’t the main cause of the market’s weakness because they aren’t really news. Had it not been for these ‘news’ the market would have fallen on some other event or in spite of any significant news at all.

At the start of the month I started pointing out that the market had com too far too fast and we were about to see another cycle high: Stock Market Rally Hitting the Wall. Since then the confirming news from sentiment, technical analysis and market internals have piled on.

Consider that we are now seeing an astronomically high level of market breadth as almost every single security out there has suddenly come to life:

I use the Nasdaq advance decline numbers because the NYSE data is notoriously polluted with non-common stock securities such as ETFs, CEFs, LPs, bonds, etc. The only time in recent history we saw so many stocks participate in a short term rally was in early January 2009. To be fair, there have been times when the stock market continues to go up in spite of breadth becoming over-extended. But these are rare and usually occur at the early stages of a powerful new bull market.

Another measure of breadth, the percentage of the number of securities within the S&P 500 Index that are trading above their 50 day moving average has reached an extreme:

On Friday, it just about reached 90% and with today’s market weakness, backed down. Anything time 80% or more are above their 50 day moving average, stock prices in general either slow down their pace or simply top and fall.

We’ve also seen an very rare occurrence in the same indicator’s short term perspective. The percentage of S&P 500 (SPX) constituents that have closed above their 10 day moving average has clustered above 80% for most of March and April 2009.

Finally, another measure of the market’s internal health, the Nasdaq McClellan Summation Index hit 241 today. This level corresponds to difficult going for any rally in the past. The only exception was during the 2003 (new) bull market when we saw breadth overextend beyond this with no ill effects to stock prices.

Sentiment
As long time readers will know from the weekly sentiment overview, option traders which had been behaving in a rather uncharacteristic way throughout the bear market have now shown their hands quite clearly. They are unmistakeably bullish with a penchant for call options vs. put options (and I’m referring specifically to trades which result in a new long position in either calls or puts).

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