Trader’s Narrative

Today Charles from the Kirk Report hosted a chat with Jason Goepfert. Here is an excerpt in case you missed it:

Yesterday’s bad start didn’t do much to tell us about what the rest of the month may hold. It wasn’t a great sign, but the last three times the S&P lost 2% on the first day of a month, the rest of the month gave returns of +14.2%, +15.7% and +3.2%….

Yesterday, columnist Mark Hulbert penned a piece highlighting October’s penchant for high volatility…

But here’s the thing…when the S&P showed a positive return over the prior month, then the average daily change in October was only +0.60%. When the prior month was negative, then the average daily change in October was +1.24%. This is an enormous difference - the average October day after a bad September was more than twice as volatile as when it followed a positive September.

Seems to me that we could be in for less volatility than normal due to the tame market over the past couple of months, and yesterday didn’t change that.

The chat was opened up to questions:

So, stepping back a bit, in your “big picture” sentiment analysis, do you have any perspective on where we might be within it right now?

Hmm, I would say somewhere near “denial” and “returning confidence”. There are a lot of arguments on both sides, which all seem cogent, but based purely on how I view sentiment, we’re not yet at an optimistic extreme, but we’re well off the “aversion” levels too.

And regarding the tip off for the end of this rally:

The biggest test for me is always how the market reacts to short-term overbought/oversold extremes. Every time we’ve hit short-term oversold since March, the market has recovered very well. Now we’ve seen a pattern of lower highs and lower lows for the second time (early July was the first), and we’ve short-term oversold. If we can’t rally from conditions like this, it is a definite warning sign that there is eager selling pressure.

Jason also featured these two disparate charts which answer just how much speculative activity we are seeing and in what form:
Continue reading ‘Today’s Chat With Jason Goepfert & Charles Kirk’

Last week we looked at the levels of cash and free credits being held in institutional and retail trading accounts in the US: Mutual Fund Cash Levels & NYSE Free Credits. I briefly touched on a research report on mutual fund cash levels by Jason Goepfert, who by the way, runs a great service at SentimenTrader. However, I wrote that:

Unfortunately, Goepfert’s research report does not take into consideration inflation or deflation but simply adjusts the level of mutual fund cash levels according to the 90 day T-Bill rate. I’ve sent him a message about this so hopefully when he’s back from vacation he can update it with this new twist thrown in.

Upon his return, Jason accepted my suggestion and lost no time in whipping up a new indicator which takes into account the added variable of inflation/deflation.

To be able to understand what this new chart is saying, it is helpful to go back to the award winning research report. In it, Jason argues that before we try to use mutual fund cash levels as an indicator, we need to adjust it for the prevailing interest rate environment. For example, in the 1980’s, with interest rates in the double digits, there was ample reward for sitting in cash. Stripping out this effect, therefore, is important because otherwise it is a distortion.

Using statistical modeling, we can determine how much cash should be held by assuming a certain level of interest (90 day T-Bill rate). After that, it is easy to compare the actual cash levels to this theoretical level to determine if mutual funds are overweight or underweight cash. Looked at this way, mutual fund cash levels are neutral, telling us that managers are neither overweight or underweight cash right now.

Alright, so what happens when we also take into account the effect of inflation or in today’s case deflation? In other words, the real rate of interest?

A completely different picture emerges. This isn’t surprising because we are currently experiencing real interest rates close to +6.5% - a far cry from the nominal rate of 90 day T-bills. Here is the inflation/deflation adjusted chart of mutual fund cash levels:
Continue reading ‘Mutual Fund Cash Levels Adjusted For Inflation’

We’ve touched on the epic amounts of cash that are sitting on the sidelines in money market funds. There is some debate about how positive this is for the market so let’s take a closer look by going over a few details from both sides of the argument.

Money Market Levels
Now that we have stepped away from the precipice (or so it would seem), it may be difficult to imagine the magnitude of fear that drove the vast majority into the safety of cash. At its zenith, we had almost half the capitalization of the total US stock market sitting in money market funds.

Here’s a chart of the aggregate US equity market capitalization compared to the total assets held in money market funds (click to see full size chart):

And at the March 2009 low, for the first time in 16 years, US money market funds had more assets than US equity mutual funds: Tsunami of Cash Waiting to be Invested. Since March 9, the value of U.S. equities, measured by the Wilshire 5000, has increased by $4.4 trillion. And from its high the level of total mutual fund cash has fallen by $341 billion.

However, before you get excited and start to think this means we are about to embark on a wild bull market, consider the astute point made by Gestalt: that the increase in money market assets may be a mirage as corporations have shifted short term liquid assets from commercial paper to institutional money market funds.

Mutual Fund Cash Levels
Jason Goepfert wrote an award winning research report in 2004 regarding the signal value of the level of cash held by mutual funds. You can get a copy of the research report from the free trading resource section (Charles H. Dow Awards folder).

As you can imagine, it is an important point in all this is that nominal interest rates are negligible. This means there is little incentive to park assets in cash. But then again, if you follow the strong indications of deflation, the real interest rate is 6.5% - which is actually a significant incentive to just let your money grow (albeit slowly) with near zero risk.

Unfortunately, Goepfert’s research report does not take into consideration inflation or deflation but simply adjusts the level of mutual fund cash levels according to the 90 day T-Bill rate. I’ve sent him a message about this so hopefully when he’s back from vacation he can update it with this new twist thrown in (here it is: Mutual Fund Cash Levels - Adjusted for Inflation).

In any case, right now, this ‘rate adjusted’ model is smack dab in neutral territory. Not helpful at all. It was moderately bullish at the spring low but since then, as the market has improved and as sentiment has thawed, this indicator has backed off into ‘no man’s land’.

NYSE Free Credits
You’re probably familiar with Margin Debt levels, which measure the level of liability in brokerage accounts. Free Credit statistics in contrast, reflect the available, free and clear cash that investors are holding in their trading accounts. This data is released regularly by the NYSE and shows how much liquid assets are held in aggregate by clearing firms overseen by the NYSE.
Continue reading ‘Mutual Fund Cash Levels & NYSE Free Credits’

The first time we looked at the Credit Suisse Fear Barometer, it didn’t look like it had anything useful to offer. But using it in combination with its competitor, the VIX index, it may yield surprising insight into options sentiment and the stock market.

The VIX has declined from its stratospheric highs to reach close to its long term average of 20. That may suggest that there is little fear in the market. But that isn’t really accurate because right now traders are willing to pay more for put options than for (equivalent) call options. We can tell that because the CSFB is higher.

The last time we had a CS Fear Barometer rising while the CBOE volatility index was falling was in early May 2008 (shown above) - just before the S&P 500 rolled over into another waterfall decline.

Source: Battle Of The Fear Indexes

That is just one instance but the others also provide the same general idea. The S&P 500 has a very tough time on average, going up when the VIX has fallen and the CSFB has gone up.

So it seems the ugly duckling of an indicator has suddenly become a swan. When paired with the VIX, the CSFB seems to unfold even more meaning for the stock market.

Check out my original review of SentimenTrader.com to see why I highly recommend Jason’s insights. As you can see from the above analysis, he’s well worth your money.

Last week there was a lot of chatter about a technical formation called a ‘golden cross’ which is considered to have bullish implications. This is when a short term moving average (usually a simple 50 day MA) crosses from below to rise higher than the long term moving average (usually a simple 200 MA). Because moving average tend to move in lethargic arcs, these types of formations are easy to foresee.

In keeping with everyone’s watchful expectation, the S&P 500’s 50 day moving average closed at 900.54 on June 24th 2009, rising slightly higher than the 200 moving average (897.19).

Since we’ve compared the current market to the nascent 2003 bull market in many different ways: breadth, wedge formation, flag formation, Weinstein analysis, etc. It is only natural then to take a look at the golden cross that presaged the bull market in 2003:

In the charts, the blue line is the 50 day moving average and the red line is the 200 day moving average. Marked by the green arrow, the medium term moving average crossed higher than the longer term moving average in May 15th, 2003.

But does the golden cross really deserve its bullish moniker? Obviously we can’t base any conclusions on one single observation in 2003.

Vincent Delisle of Scotia Capital looked at 14 previous S&P 500 bull markets (lasting on average 49 months and rising 149%). From these only about 17% of the gains materialized before a golden cross signal was given. After 12 months of a signal the average gain was 23%, implying that a golden cross doesn’t arrive too late to provide forward returns. Delisle adds that a golden cross appears to have more validity when it occurs with a rising 200 day moving average - something we had in 2003 but do not have now.

By the way, a “death cross” is the opposite and can be seen on the above chart marked by a red down arrow.

According to Jason Goepfert of SentimenTrader, any edge offered by golden crosses is minimal. Identifying the same distinction as suggested by Delisle, he looked at only instances where the 200 day moving average is declining.

Goepfert concludes:

…the returns going forward, up to six months later, were little better than random and not statistically significant. In fact, in the shorter-term they were a little worse than random. Only when we look out a year do we see some out-performance.

But he does agree with Delisle that most ‘unsuccessful’ golden cross signals coincide with the early 1940’s and that more recent examples have had much more success. The S&P 500 was positive 11 out of 13 times since 1942 with an average annual return of 18%.

Finally, a reader was kind enough to forward a recent research report from Merrill Lynch on golden crosses. I’ve added it to the Free Trading Resource Section and you can download it from the Articles & Reports folder.

In the Merrill Lynch report prepared by Mary Ann Bartels, it continues to distinguish between golden crosses that happen with a downward long term moving average and those when the long term moving average is rising:

Of the 42 Golden Cross signals triggered since 1928, 20 have occurred with the 200-day moving average in a declining trend or lower than it was 30 trading sessions ago. These signals on average have generated 12-month returns of 13.3%.

The remaining 22 signals occurred when the 200-day moving average was rising or higher than it was 30 trading sessions ago. The returns for these signals were much lower and on average generated 12-month returns of 5.7%.

This is bullish for today’s market since the long term moving average of the S&P 500 is still falling. The report is full of insight backed by stats so I highly recommend you download it and take a look. Bartels also adds a new overlay by looking at golden crosses that happen during a recession (as defined by NBER). Signals that meet the condition of a declining 200 MA and a recession suddenly produce an average 12 months return of 23.3%.

Not surprisingly, her conclusion is that “the equity market remains in a base-building process that should lead to higher returns.”

Of course, that doesn’t mean that the market automatically heads higher and higher from here. Base building can be soul crushing. Ask any trader that lived through the 1970’s - no wonder everyone started wearing platform shoes