Trader’s Narrative

Here’s this week’s sentiment summary:

NASDAQ:NYSE Volume
I touched on the relative lack of volume and how this has historically marked tops, rather than spurred on rallies. Another troubling volume development is the ratio of volume on the Nasdaq compared to the NYSE. We are seeing a spike in this ratio, meaning that Nasdaq volume is significantly more than NYSE volume. Since the Nasdaq represents the riskier side of the market, this has usually meant that there is too much froth in the market.

Sentiment Surveys
Last week I pointed out the danger of having the AAII remain at 53% bullish when the market had gone down slightly. Although this week the AAII respondents were slightly less bullish (45%) it is good to see their excitement abate in the face of a week that saw the market go up.

This reversal however only slightly dilutes the contrarian bearish meaning of this indicator. We are still at a very high level of bullishness. Simply by receding from the extreme level of bullishness that we saw last week does not eliminate the topping signal that the AAII is giving us at this point. After all, it was in October 2007 when we last saw this sentiment measure at such heights.

Investor’s Intelligence, the measure of newsletter sentiment compiled by ChartCraft, showed little change going from 44.4% bullish to 46% bullish.

Hulbert Newsletter Sentiment Survey
In contrast to the sentiment surveys mentioned above, the Hulbert Stock Newsletter Sentiment Index is continuing to suggest that newsletter editor are still either skeptical of the market’s recovery or not really excited by it.

At the start of the week, the HSNSI was 16.2%, meaning that the average market timing newsletter was suggesting to their clients being long just 16.2% of their portfolio. This is much lower than the 27.5% which they were recommending in late April, even though at that time the market was lower than it is now.

Slicing and dicing the newsletters, Hulber finds that the stock market newsletters with the best track record of timing the market are continuing to be bullish, while those that have lagged buy and hold are much less so. This gap in sentiment and performance has, however, significantly diminished from mid-March - when the market hit its inflection point.

Is LowRisk Dead?
A reader already asked about the lack of updates from LowRisk. I emailed Jeff Walker, the keeper of the data and when or if I receive a reply I’ll write a follow up. The last update on their site is for March 23rd 2008. I haven’t received any email updates either - I’m subscribed. In any case, LowRisk was never one of the major sentiment surveys that I relied on. It was a bit too volatile and no one except Walker knew the size of the sample size.

Magazine Cover Indicator
Here’s an interesting magazine cover for analysis (below): “Barbarians at the vault”. It is the latest Economist cover showing a bank being besieged by a horde of angry “barbarians” carrying banners with such slogans as :

• Skin the fat cats!
• Just say no to CDOs
• Regulate now
• Salary limits

The building is on fire, there is a column being pulled and there are sledgehammers being taken to its pillars. Pretty powerful imagery. I wonder how it will play out with the Philadelphia Banking Index being where it is:

Check out the Economist’s “prowling bear” cover in 2006. As disclosure, I’m long the AMEX Financial Select Sector ETF (XLF).

On Wednesday - February 13th - after 3 consecutive up days, I mentioned the peculiar way that option traders were in denial of the rally and of the likelihood of seeing a pause:

It would be very normal for the market to pause and digest this short term move up but the negative sentiment is undeniable.

We got the “pause and digest” the following day on Thursday and today. So to dive into all that negative sentiment, here is the stock market sentiment recap for this past week:

LowRisk.com
I mention this sentiment survey sparingly because it is very jittery and much less famous than its peers. But this week’s reading of 64% bears and 24% bulls reminds me of the last time that bearish sentiment was 60% (June 2007).

Unlike then, this week’s bullish ratio (bulls divided by the sum of bulls and bears) is quite high at 27.27%. But there is no denying that the respondents are very gloomy about the Dow’s prospects. Their median guess of the Dow (closing value February 22nd) was 11852 - well below the Dow’s January swing low of 11,970.

Investor’s Intelligence
If you’ve been keeping up to date with these sentiment overviews then you know that the II survey has been insistently and stubbornly stuck with a clear bullish consensus. For contrarians, that has been disconcerting not only because II is a major sentiment survey but because it contradicted all the other surveys.

This week it seems “reason” has finally prevailed in newsletter land. According to ChartCraft, the keeper of this indicator, the bears now account for 35.6%, and the bulls 36.7%. While that may seemingly put them neck and neck, the historical data for this survey gives us a decidedly more bullish interpretation.

Newsletter editors are naturally bullish by nature, after all, optimism sells. So it is almost impossible to find less than a third of them bullish at any point in time, no matter what the market condition. The current percentage of bulls is as low as it was in the summer of 2006 and 2002 (and no other time since). So I can comfortably say that the II is officially flashing a contrarian buy signal - finally!!.

AAII
Meanwhile, the AAII (retail investors) sentiment has finally decided to come up for air from the depths of despair it had sunk to in January 2008. The AAII sentiment survey spent 5 consecutive weeks (December 21st, 2007 to January 18th, 2008) being 50% or more bearish. The bears are now “only” 42% (with the bulls at 33%).

We’ll have to wait a few more months to see if the stock market follows the previous script or if we stray. According to the above chart, we could find the S&P 500 at 1558 by June 2008.

That’s not a prediction, by the way. I’m just extrapolating from the historic averages. But it could turn out to be prescient, so write it down somewhere or bookmark this so you can come back and mock me

Consumer Sentiment
The most recent Reuters/University of Michigan’s consumer sentiment survey was released today and it shows a stumble from 78.4 to 69.6 - the lowest since 1992!

As I’ve discussed before, consumer sentiment measures are a contrarian indicator. By the time they reflect doom and gloom, it is too late to sell, and in fact a better time to buy.

Whether that is because of the time lag built into this kind of survey or whether it is because of the forward discounting ability of the stock market (or both), the historical evidence shows that significant lows in consumer sentiment are buy signals for stocks.

I’ll going to write more about this indicator soon.

Let’s take a quick look-see at the sentiment for this past week:

ISEE Sentiment Index has backed off the low extremes considerably and hit 125 - so retail option traders are buying slightly more calls than puts. This is to be expected and unless we see this indicator reaching +200 the rally shouldn’t be in danger.

Short interest ratio is the number of shares of stock sold short compared to the average daily volume. On the NYSE, this ratio is close to 9. By itself this would be astonishing because it is the highest ratio in history. But there is more going on than simply rampant shorting of stocks. A new structured fund product has taken off on Wall Street, sucking in billions of dollars to a long/short strategy.

The AAII sentiment has ameliorated slightly with just 49% of retail investors feeling bearish this week. But still only 30% are bullish, leaving us with quite a bit of left over panic.

LowRisk’s 30 day outlook continues to be mired in absolute dejection: 59% bearish and 36% bullish. The remarkable thing is not only the degree of bearishness but that there are so few fence sitters (only 5% are neutral).

The troublesome Investor’s Intelligence sentiment continues to back off its bearish signal of the last few weeks. This week bulls are only 40% - a level we reach at intermediate market bottoms. The past few times we got this low were: summer 2004, summer 2006 and August 2007. Having said that, we still are not seeing any sort of panic in newsletter-land.

The Hulbert Stock Newsletter Sentiment index is mirroring the II picture with only an average of +10.1% exposure recommended by stock market timing newsletters. Seeing how the historical maximum is +79.7% and the minimum is -81.8%, things are decidedly lukewarm. But Mark Hulbert, keeper of the HSNSI interprets the concomitant rise in bullish sentiment with market prices to mean that the rally is hollow and bound to retest the recent lows.

Recent Yahoo! (YHOO) holders are all too familiar with a retest of lows. That is, before this morning’s surprise announcement from Microsoft (MSFT) regarding their amorous intentions. If you were holding YHOO, I hope you took at least some money off the table.

UPDATE: Its been a while since I mentioned the TickerSense blogger sentiment poll but I just noticed that the bulls are at only 24% while the bears are at 44%. This is the highest disparity between the two camps since March 12th, 2007 when bloggers were 13.16% bullish and 42.11% bearish.

I’m a bit wary of giving this too much weight because of the edgeless nature of this particular sentiment indicator. But if you notice, there’s been a remarkable switch since last August: bulls have been more predominant than bears. So now, after months and months, we see the bulls finally capitulating. There may be something in that pattern.

Alright, here is the belated sentiment overview for the past week:

Sentiment Surveys
There was hardly a change in the LowRisk numbers with still about 57% bearish and only 32% bullish. The AAII bears increased to 59% while the bulls remained almost constant at 25%. So the retail investors are still very frightened - which is good from a contrarian perspective.

Although the bears increased and the bulls decreased, the Investor’s Intelligence survey of newsletter writers continues to be the “odd man out” because it is still showing more bullish sentiment than bearish (41.6% vs. 31.5%).

This dichotomy of sentiment between the newsletter writers and retail investors is rare but it has occurred before. Usually we can discount it because of the subjective method that II uses to come up with the results. But we have confirmation from the Hulbert newsletter sentiment indicators. So for whatever reason, newsletters have not thrown in the towel, despite the +20% market decline. This could be a fly in the ointment, unless we see them capitulate soon.

ISEE Index
The CBOE equity only put call ratio spent several days above or at the 1.0 threshold (click for graph). With the short term market recovery, it has backed off to 0.67 - a neutral reading.

I prefer the ISEE Sentiment Index to the traditional CBOE put call ratio because it provides a clearer picture of the “dumb money”. By the way, when I use a term like that, I hope I don’t offend anyone. It’s just a word that describes a theoretical group of market participants out there.

Here’s a chart of the ISEE Index going back to early 2007:

The previous times it has come down as low as it did recently were very good times to be a buyer: early March 2007, August 2007 and late November 2007. Although we’ve recovered from those lows, as long as the ISEE doesn’t go too high too fast (above 150), we have the stage set for a continued recovery.

Magazine Covers
On the left, is the most recent Economist magazine cover page. The gloomy picture of a man bracing himself against a blustery storm with the superimposed red line showing the dropping stock market is a great negative image. I haven’t had a chance to read the accompanying article but the fact that they went along with this image and the title: “It’s rough out there” gives us all we really need.

To contrast that, Barron’s cover page is a bit more nuanced. Although it shows a bear captaining the ship of the market, a bull is about to “whack” it from behind with a baseball bat (ala Deniro). No doubt, this is a bullish cover and from a strict contrarian point of view, problematic.

But you have to remember that Barron’s is a specialized publication, written for and read by the financially literate. They were the ones that had many prescient covers, including the infamous “Dot Bomb” cover which presaged the bursting of the internet bubble. So I’m not in a hurry to see this as a bad omen.

My continued bullishness may be seen by some as stubborn, but after looking at the sentiment out there, what other position can you take?

Option Traders Freak Out
The ISEE index recovered from a low of 60 - a low enough level to show severe panic in retail option traders. Although we don’t have long term data for this ratio, the data that we do have indicates that this is low enough to stoke a rally or at least halt a decline.

The more traditional CBOE (equity only) put call ratio once again came in near 1.0 today - this is the third time this week that it has been above or just at parity. In the past 4 years, we’ve only seen parity broken a handful of times. But to see a grouping of such high put call ratios is highly unusual.

I think it is safe to say that option traders, and especially the least experience and least capitalized of them (retail) are in full freak out mode:

Sentiment Surveys
The only traditional sentiment measure that is not showing excessive bearishness is Investor’s Intelligence with 45.6% bulls and 26.7% bears. A few people have asked me about the disparity between it and other sentiment indicators. Honestly I don’t know what is really going on but as I’ve said before, you have to understand that it is very different from other measures.

For one, newsletter writers are a generally more optimistic bunch (since bullishness sells better than its counterpart). Second, II is tabulated through the subjective thinking of one person, Michael Burke. He categorizes newsletters as either bulls, bears or neutral from not necessarily their portfolios but also what the writer is saying. Since the newsletters can’t themselves, in effect, “vote”, this measure is open to the personal bias of one person.

So maybe that explains the discrepancy or maybe it doesn’t. In the end, it is one measure among many. I’d rather take the general judgement of the group, than single out any one of them.

LowRisk’s recent 30 day outlook is decidedly gloomy with 56% bearish and 32% bullish. Market Vane’s bullish percent dropped to 48% and although that sounds too high already to be bullish, you have to consider that for the past 4 years, it has oscillated between 75% and 55%. Likewise, Consensus‘ bullishness is at 47%.

AAII is showing panic-level bearishness again with 54% bears and only 24% bulls. Check out last week’s chart to see the correlation between such high bearish AAII sentiment and stock market performance.

According to Jason Goepfert, waiting two weeks after a bearish percentage above 50% gives us a better chance of finding a winning trade: 24 from 29 instances with an average return of +3.1% (over two months). He also says that the “average drawdown (i.e. maximum loss) of -3.2% was dwarfed by the average maximum gain during the trades of +5.7%.”

Rydex Ursa/Nova Ratio
Before leveraged ETFs, the only way retail traders got long or short aggressively was through the Rydex Nova/Ursa funds. Although they have become somewhat of an anachronism, their ratio is still useful to show the retail investor’s mood.

Not surprisingly, we are seeing a dash into the bearish leveraged fund (Ursa) as the “dumb money” goes into panic over the recent market losses.