Trader’s Narrative

Here’s an interesting chart from Merrill Lunch’s recent “Hedge Fund Monitor” report. It shows that traditional long short hedge funds have returned to a historically normal market exposure after the shock late last year:

With the end of the year barreling closer, hedge funds, like any other money manager out there wants to coast to an easy finish and hang on to their gains to be able to bank their lucrative incentive fees. One safe strategy is to sell their long positions and replace them with calls to have the best of both worlds.

This may explain one of the only places where we’re seeing some cautionary signs of exuberance. In last week’s sentiment overview I mentioned that the options pits is showing an awful lot of calls being bought relative to puts. While I’m hesitant to outright dismiss any irksome metric, some of that can be explained away by the penchant to lock in gains via calls. However, not all of it can be attributed to portfolio managers trying to coast to large Christmas bonus. That’s because the ISE sentiment which exclusively measures retail option traders is showing similar indications of exuberance.

Another interesting tidbit from the ML report is that hedge funds have on average reduced their exposure to ‘high quality’ stocks since April 2009. That makes sense since retreating into safer issues is a tried and true strategy in times of distress. Right now though, more speculative equities are getting most of the love. And that’s exactly what we’re seeing in the breadth measures as almost every single Nasdaq and NYSE stock participates in the rally.

You can download the whole Merrill Lynch report from the FREE trading resource section (check in the Reports & Articles folder).

Here is this week’s sentiment round-up:

The AAII weekly sentiment survey shows that the consensus reversed suddenly from the giddily bullish extreme that we saw last week. The bulls fell to 37%, a decline of 17% points. And the bears increased to 40% coming to an almost perfect equilibrium.

While this is a dramatic decrease in their level of optimism, I’m still cautious. The last time we had the same level of bullishness in the AAII survey was in early May 2008. And as I mentioned during last week’s sentiment overview, the stock market didn’t roll over immediately in response. The S&P 500 actually climbed slightly higher in the following weeks. So just because the market has overtaken last week’s highs does not absolve it from a potentially mortal weakness.

The average exposure recommended by stock newsletter editors (as measured by the Hulbert Stock Newsletter Sentiment Index) fell to 30.3% - that’s a sharp decline of 17% points from just 7 days ago. From a contrarian point of view, if the level of bearishness continues to rise even as the stock market rises, then it would imply that this rally still has some life left in it. But we aren’t there yet.

This week’s Investors Intelligence survey was little changed from last week: the bulls were at 48.3% and the bears at 23.1%. This is the only sentiment survey that is dancing to its own tune.

According to the AAII asset allocation survey equity allocation has reached 57% - a level last seen before the equity markets started their cascade down last year.

We touched briefly on the bond allocation at the beginning of the month. At 25% (a 9% point jump!) it is not only the single largest increase but also brings bonds to the highest chunk of the AAII portfolio it has ever been since 1987 when they started keeping track.

Finally, to round off, retail investors are finally feeling comfortable enough to leave the safety of cash. After the cash portion of their model portfolio reached a peak of 45% earlier this year, it is now down to just 25%. As I’ve mentioned before, there is a massive pile of cash sitting on the sidelines and it is slowly being deployed. Of course not all of it is ending up in the equity market, but considering the size of the build-up, even a small portion can have a significant effect.

The NDR Crowd Sentiment Poll is a proprietary sentiment measure from Ned Davis Research. It surpassed its extreme level (61.5) last week. Since then however it has backed off from this threshold and is now 4.3 points lower to 59.1 - this is similar to the other sentiment surveys covered above.

Fund Manager Survey
According to a Merrill Lynch survey of 204 fund managers, managing a total of $554 billion, 75% believe that the global economy will improve in the next 12 months. That is the highest level of optimism since November 2003. A smaller amount (70%) expect corporate profits to rise in the coming year.

Fund managers are putting money where their mouth. They have reduced their cash levels from an average of 4.7% in July to 3.5% in August - the lowest level since July 2007. They have also increased their allocation to equities sharply from last month. Merrill Lynch’s Risk and Liquidity Indicator, which measures risk appetites is at a 2 year high.

This dovetails nicely with what we are seeing from the AAII model portfolio allocation (above). The build up of cash was a sudden, fear induced spike. But the unwinding of it is more orderly as a gradual stream of investors decide that it is safe to venture out once more and take risks again.

Option Traders
The CBOE (equity only) put call ratio continues to fall as optimistic traders prefer calls to puts. Friday it closed at 0.51 meaning that traders were trading twice as many calls as puts. The simple 20 day average of this ratio is now at 0.587 - the lowest since June 2007:

Perhaps more importantly, the short term moving average has as a result, broken well below the multi-year rising channel that contained the put call ratio (red arrow).

The lesser known ISE sentiment index (equity only) reached a high of 202 on Friday. Being a call put ratio, this means that for every 100 puts, there were 202 calls being bought. But the short term moving average of this indicator is still treading water and not at an extreme.

Magazine Cover Indicator
Here is the August cover for Futures - a magazine dedicated to news and analysis of options, futures and stock trading. It is not a general interest magazine like Newsweek or even Business Week so I’m not sure how much contrarian weight we can put on it.

In any case, the image is of a hazy outline of a bull appearing in the distance. The implied question is, “It might be, it could be, is it?” meaning a bull market. Obviously this is the question that many are grappling with.

The interesting aspect of this cover is that it is not boldly trumpeting the arrival of a new bull market but instead timidly asking if it might be, could be true. And finally, wondering if it truly is.

By the way, if you have a US mailing address, for a limited time you can get a free subscription to Futures Magazine. I’m not sure how long this special offer will last so sign up right now.

Consumer Confidence
The preliminary Consumer Confidence survey from Reuters/University of Michigan showed a surprising decline to 63.2 for August - back to a level not seen since March 2009 when the market hit its trough. It would seem that the US consumer is being buffeted with the cross winds of deflation, which make things more affordable, rising unemployment and a schizophrenic stock market. No wonder then that they can’t seem to make up their mind:

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

Here is this week’s stock market sentiment overview:

Sentiment Surveys
In last week’s sentiment overview, ChartCraft’s Investor’s Intelligence sentiment survey came in at a 14 year low (for bullishness). This week there were only 22.4% bulls with bearishness remaining unchanged. This week’s numbers take the II to a 20 year record! From a contrarian point of view, the message is clear.

The AAII sentiment survey is whistling a different tune however. The bears fell dramatically from 61% to 40% and the bulls rose to 41%. That’s a dramatic shift. Not only for the decrease in bears but because technically we now have slightly more optimists than pessimists. For confirmation of a market bottom and a healthy rally, I’d prefer to see continued doom and gloom.

There was a similar uplift in mood for the Consensus sentiment survey. Bullish sentiment rose from last week’s 21% to 36%. Again, not the sort of thing that gives contrarians confidence for a sustainable rally.

Volatility
Now this is just insane. The VIX closed the week at 70.33 - that is a record, in case you’re keeping track. But a new all time high record isn’t what makes my eyebrows levitate. It is that the VIX ended higher than on October 10th 2008 - when the market closed lower than on Friday. So while the market is now higher, fear - as measured by the VIX - is actually more pronounced. Interesting.

TED Spread & LIBOR
The credit markets are continuing to thaw with both LIBOR and the TED spread falling. But, and that is a big but, we are no where near normalcy. Both indicators are at extremely elevated levels. They difference is that they are now going in the “right” direction (if you are a bull). But they still have a long ways to go to totally unwind.

Sell Side Indicator
The Sell-Side indicator measures the equity allocation recommendation of the average Wall St. strategist to their clients. As you can imagine, as a group they are a great contrarian indicator just like the newsletter editors (Investor’s Intelligence) or the retail investors (AAII). Here’s a good article which explains it in more detail.

Right now the average allocation is 58% - which is the lowest level in 10 years. However, if you look back more than that, it is clear that we are near levels which would only suggest a cyclical bottom for the stock market, not a secular one (at best):

University of Michigan Sentiment Survey
If we needed another sign that the US consumer is totally pessimistic, the recent Michigan sentiment survey shows an even lower reading than the last time I mentioned it in May (Conditions of a New Bull Market: Consumer Sentiment). At 57.5%, it is now lower than anything we’ve seen in almost 30 years. This is saying a lot when you consider all the shocks that the financial markets have been buffeted with over that time:

The lowest reading in the history of the survey was in May 1980, 51.7%. This most recent result is preliminary and may be changed when it is finalized on October 31st 2008. We actually saw a lower reading than this most recent number in June 2008 with 56.4%. Then things seemed to improve to 70.3% only to fall down again. In any case, these small details matter less than the overall picture showing a shell-shocked consumer.

As you’d imagine, in the upside down world of contrarian sentiment, extremely pessimistic consumer sentiment is bullish.

Hedge Fund Redemptions
Forget mutual fund redemptions, hedge funds, the sophisticated investment vehicles of wealthy individuals and institutions is hemorrhaging assets to the tune of $210 billion. It seems most aren’t absolute return vehicles but closed index funds because in the recent quarter, they produced terrible results for their clients. According to hedge fund watchers, this looks to be the worst year both in terms of asset flows and returns.

Of course, not all hedge funds suffered. Andrew Lahde posted +860& returns and closed shop after just one year.

Interesting day. So now the chatter on bonds has risen to a crescendo. Before it was the Chinese market, and before that the Yen. No matter what the market does, something is trotted out after the fact to try and explain it.

If this drop happened last week we would have been told it was China’s fault. And yet, the Shanghai market has fallen more than 20% and we’re still doing just fine (considering what happened earlier in the year).

A few amazing tells happened this week regarding interest rates. The brainiacs in Goldman Sachs’ (GS) economics research team threw in the towel. They had been predicting a total of 75 basis points decrease in the Fed fund rates since last September. Things didn’t exactly play out that way. Now they are saying that no cuts will be coming, even in 2008.

And just one day before GS’s about face, on Monday, it was the guys over at Merrill Lynch (MER) who had enough of predicting rate cuts. Their call was even more extreme, calling for a 100 basis point cut! But now they agree with their colleagues over at Goldman and are expecting no cuts going forward.

Which means that the sentiment landscape is becoming rather lopsided. Not many bond bulls around it seems.

The Commitment of Traders report is nicely bullish, although not at a historic extreme. The same can be said of all other tecnical and sentiment metrics that track the bond market:

Consensus Survey: mildly bullish
put call ratio of 30 year bonds: mildly bullish
Market Vane Survey: neutral
Rydex ratio: mildly bullish
distance from 50 day MA: bullish

Unless we get a nice, sharp rally to reign in the bond bears, it could get real ugly. The worst is just dripping lower. The best is a nice sharp drop or a nice sharp rise - to signal exhaustion.

Considering the relative weakness of the banking sector, we better have some sort of resolution. And fast. Otherwise, the whole premise of a continuing bull market is once again up for debate.