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).

This week sentiment recovered from the abyss into which it had fallen. This isn’t surprising considering the strong lift-off the market had last week. But even so, it doesn’t yet give us any reason to doubt the veracity nor the potential of the rally to continue.

Hulbert Newsletter Sentiment Index
According to Mark Hulbert, the Hulbert Stock Newsletter Sentiment Index (HSNSI) was -22.5% on Monday, March 24th, 2008.

On March 10th, 2008 when we had the lowest close in recent history, the HSNSI was a little bit lower at -25.9%. Which means that although the market has recovered from such lows, the average market timing newsletter writer is still very much bearish and recommending to their subscribers that they in fact short the market in their portfolios!

This is even more significant when we compare the reaction this rally has provoked to the previous rally in mid January. Right after the market recovered from those intra-day lows and went higher, newsletters quickly jumped on the bandwagon and the HSNSI increased right along with the rally more than 22% points.

This is exactly what I was referring to when I answered Jim’s question about trend and why I’m not bearish in the current market condition.

Sentiment Surveys
The AAII retail investor’s sentiment survey continued to recover with an increase in optimism: 42% were bullish and 34% bearish. This puts them square in neutral territory.

The II (ChartCraft’s newsletter sentiment measure) similarly recovered with a small decrease in the number of bears (41%) and a small increase in the bulls (36.7%). But unlike the AAII, the newsletter editors are still very much at extreme levels of bearishness which have historically coincided with market bottoms.

Although sentiment has shifted from the lopsided scenario we had, I don’t think this means that the rally it birthed is in danger. For the market to go up we need people to start buying again and for that, they need to not be so afraid. That, however, is different than a quick shift from one extreme side of sentiment to the other.

ISE Sentiment
This week we’ve seen a consolidation after last week’s rapid recovery. The ISE Sentiment Index, however, is showing that this has lead the retail option traders to quickly lose any excitement for the rally:

ROBO Put Call Ratio
This proprietary measure created by Jason Goepfert of SentimenTrader.com keeps track of what the small retail option traders are doing.

The most recent data is showing that the retail investor is very worried. The ROBO put call ratio is 0.91 - that’s from 0.68 in mid February 2008.

To find similarly pessimistic times when the retail investor was buying puts so frantically, we’d have to go back to early 2003, just as the bear market was coming to a close.

Because of the delay in getting OCC data, this reflects what was happening in the option market last week. But it is nonetheless useful on an intermediate to long term time horizon.

Is it just me or is this tape incredibly frustrating? We’re dripping lower, seemingly on our way to test the January lows. But it is anyone’s guess if we we’ll get a head fake lower and then reverse up or just cascade down into a continuous bear market decline, ala the 1970’s.

To help light the way, here is the sentiment overview for the past week:

Hulbert Newsletter Sentiment
According to Mark Hulbert, the keeper of the HSNSI (Hulbert Stock Newsletter Sentiment Index), there is contrarian arguments that the January low will be intact.

This week’s market decline brought down the portfolio allocation of stock newsletters to -16.4%. That means the average market timing newsletter iss advising their clients to be short the market.

The HSNSI is now not only below the January 22nd lows, it is the lowest such sentiment reading since October 2005 when it scraped -30%. The silver lining in the clouds is that newsletters are dejected and starting to throw in the towel. They are not stubborn in their denial of a declining market. That, according to contrarian analysis, sets the stage for a potential rally.

Option Market
As I pointed out yesterday, the CBOE’s equity only put call ratio spiked to a four year high. Today it retreated to 0.90 - still quite high but backing away from everest proportions.

On Friday it was the ISEE Sentiment Index’s day to turn heads. I suppose the retail traders read the headlines and watched the TV reports from Thursday’s trading, got freaked out of their minds and started buying puts hand over fist, pulling the ISE sentiment index fdown to 65 - the lowest it has been since January 17th of this year.

On that day the ISE index was 60, meaning that retail traders were only buying 60 calls for each 100 puts. Strangely enough, the market bottomed a few days later (January 22nd or 23rd, depending on whether you go by the intra-day low or the close) when the ISE ratio was much higher: 105 and 98!

This is exactly what happened during the March 2007 retest of the bottom. During the first decline, the ISE sentiment dipped to the 60’s but during the subsequent retest, it was at par (100).

AAII Sentiment Survey
Finally, among the sentiment surveys this week, the AAII results stand out with a meager 22% bullish and 50% bearish (again). During the January decline, the AAII survey showed similarly low bullishness but the rally it ignited was mild to say the least. You remember this chart, right?

We’ll have to wait a few more weeks to see if it will be borne out but it is an understatement that so far, it has been a disappointment. By the end of this month, we’ll have given it the 13 weeks it requires. Let’s see if the AAII contrarian sentiment analysis lives up to its history - mark your calendars!

Investor’s Intelligence
In agreement with the retail investors, this week’s Investor’s Intelligence sentiment survey shows the newsletters at 42% bullish and 37% bearish. Both those levels correspond to extremes, which can be interpreted according to contrarian thinking as very bullish for the market.

To wrap up, while we may have to endure some further turbulence due to our proximity to the January lows, the sentiment is horrible out there and it will set the stage for an intermediate to long term rally. The trick will be to not get shaken out of long positions while still maintaining discipline.