Trader’s Narrative

There’s much to cover in this week’s roundup of sentiment data, so let’s dive right in:

Sentiment Surveys
The American Association of Individual Investors’ weekly survey of sentiment doesn’t show much change. About 39% think the market will go higher - that’s 3% points less than last week - while 45% think the market will fall - that’s a 5% point increase from last week. All in all, the AAII survey hasn’t given us a signal definitive signal since August when it blinked red (excessive bullishness) and earlier in March when it blinked green for excessive bearishness.

The Investors Intelligence survey of newsletter editors on the other hand continues to insist that there are about twice as many bulls as bears: 46.7% bullish and 24.4% bearish. We’ve seen a gentle amelioration in the optimism from last month but still, 2:1 is rather extreme.

Since we’re slicing and dicing sentiment through various surveys, why not take a look at what the millionaires are thinking? The Spectrem Millionaire Investor Index and the Affluent Investor Index are the only one of their kind (if I’m wrong, let me know). Few wealthy investors are ready to jump back into the stock market. Right now they are fond of cash and growing fonder of bonds. While still very cautious towards equities, they have started to tip-toe back in. According to Spectrem, 70% believe a drop in unemployment will signal the end of the recession. So it seems the wealthy are not all that different from the unwashed masses - at least when it comes to their portfolio.

Michigan/Reuters Consumer Confidence
US consumer confidence continued to rise reaching 73.5 - much higher than the expected 70.5. This is the highest level of consumer confidence since January 2008 - before the equity and credit markets cascaded down in a devastating decline. The index of future expectations continued to recover as well, rising to 73 - the highest in 2 years.

This month’s Michigan/Reuters survey also provided for a very large jump in the “News Heard Index” which measures the ‘net’ bias of the good news and bad news that consumers hear. According to Credit Suisse’s chief economist, Neal Soss, the News Heard index has a very high correlation with monthly changes in consumer confidence. So maybe the US economy is starting to turn around. But even if it isn’t, if enough people believe it is, it becomes a self-fulfilling prophecy.

Rydex Traders: All In
This week’s weakness in the stock market has been enough to bring out the bargain buyers within the Rydex market timing community. Right now there are twice as many assets in the bullish side as the bearish side. Every time that we’ve seen this extreme in recent times, the market has either paused or corrected. For more information, see Guy’s blog: Technical Take.

Fund Flows Data
If you were reading the blog earlier this week, you caught the chart of equity vs. bond mutual fund flows. While it is still premature to label it a trend, the preliminary data shows that the average US retail investor is not being enticed to re-enter the stock market in the least. Not even by an astounding 57% recovery in the S&P 500. They are in fact withdrawing their money from equities and stuffing it in various bond funds. The anecdotal evidence points to a traumatized populace which has been burned so many times, it has simply decided to withdraw and not play a rigged game.

Other than the implications for stock market sentiment, which are many, this brings up another important point. Whatever the impetus for this rally, the mutual fund data suggests that the US retail investor is not it. So if the masses who were once weaned on “buy and hold” are not buying, and corporate insiders are not buying, who is exactly?

Option Traders
We patiently waited many months as the ISE and CBOE option data fed us mild gruel week after week. Now they are both showing excessive call buying as option traders push their luck that the stock market will continue to rise:

The short term average of the ISEE index (equity only) which measures retail call buying relative to put buying is now at 194. This means that on average almost twice as many calls were bought as puts to initiate a position by retail traders. The last time this indicator was at these lofty levels was in November 2007. The highest it reached during that cycle was 229 on October 15th 2007 just days after the bear market top.

And here is the chart for the 10 day moving average of the CBOE (equity only) put call ratio showing basically the same amount of excessive bullishness:

The confirmation that these two separate option sentiment indicators provides is welcomed, especially after so much time where they either disagreed with one another or didn’t flag any extremes at all. The message right now is crystal clear.

A few days ago we discussed the bearish implications of the S&P 500 being 20% above its 200 day moving average. A similar study from Quantifiable Edges based on the CBOE put call ratio data shows a similar outcome.

Gold Sentiment
Gold is once again flirting with the $1000 level. It has once again lost the four figure handle but from various sentiment indicators, we have good reason to expect this current charge to succeed in breaching the $1000 line for good.

The Hulbert Gold Newsletter Sentiment Index (HGNSI) is showing a surprising lack of excitement this time around in contrast to the other previous runs at $1000. The average exposure recommended by newsletters at previous tops was 62%. However, the HGNSI currently only stands at 39.5% (see article for more details).

The lukewarm HGNSI number dovetails with the other various sentiment indicators which I mentioned recently: Google Trends: Gold Sentiment Neutral and Various Perspectives On Gold At $1000.

Grey Beards
Let’s check in with the ‘grey beards’ - those that have either been prognosticating for a lengthy time or have been extremely prescient to win our admiration and attention. David Rosenberg continues to be unapologetically a non-believer in the current standing of the stock market. He recommends resource sectors, gold, other commodities and the Canadian dollar and Canadian government bonds.

The grumpy bear, Jim Grant has suddenly gone bullish. In a recent Wall Street Journal article Grant outlines his reasons for a more optimistic outlook.

Bob Janjuah of RBS is having none of it - as usual. He is back from vacation with a bah humbug!

All I see is growth and asset price gains driven by the willing and reckless destruction of government and central bank balance sheets.

Magazine Cover
From the contrarian perch, this week’s Business Week magazine cover is a confusing one. Because of the design, there are two covers in one that manages to be both bullish and bearish, depending on which side you hold up and read.

On one side it says: “Why the Market Will Keep Going Up” and on the other it says: “Why the Market is Going Nowhere”. Technically those two statements aren’t polar opposites. Had the negative one said “Why the Market Will Crash (Again)”, that would have been a truly contradictory statement. But then again, the stairs are leading down so maybe I’m over analyzing this. So, will the market go up or down? Yes.

The Evolution of Overconfidence
Finally, here is a fascinating article from MIT’s Technology Review about the evolutionary underpinnings behind the human propensity for overconfidence. Since it is an inherently a self-destructive behavior, how did we manage to survive and why is it part of us in the first place?

By creating a mathematical model of the way overconfident individuals compete against ordinary individuals, they show that there is a clear advantage in overconfidence.

In fact, if the potential reward is at least twice as great as the cost of competing, then overconfidence is the best strategy. In fact, overconfidence is actually advantageous on average, because it boosts ambition, resolve, morale, and persistence. In other words, overconfidence is the best way to maximize benefits over costs when risks are uncertain.

While that may be a neat and tidy explanation, the corollary is disturbing:

Their model implies that optimal overconfidence increases with the magnitude of uncertainty. So the greater the risk, the more overconfident individuals should become. Johnson and Fowler use that finding to predict that overconfidence will be particularly prevalent in domains where the perceived value of a prize sufficiently exceeds the expected costs of competing.

Sound familiar?

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I have a nagging feeling this week will be one to remember. Whether it will be the bulls or the bears that will look on it fondly, only time knows. Here is this week’s unforgettable sentiment recap:

Sentiment Surveys
According to the Investor’s Intelligence survey of newsletter editors, we already had a dearth of bullishness, but now we have historically low numbers: 31.1% to be precise. Since stock newsletter editors are usually an upbeat lot, this is actually the lowest since October 2002 and early 1995.

Not to be outdone, the AAII survey of retail investors is showing that this week, 59% of respondents are bearish. We’ve been here before; at the beginning of the year. Lets see if this time we can light a flame under this rocket.

CBOE Put Call Ratio
Although the VIX rose moderately, thanks to the panic caused by the Bear Stearns (BSC) debacle, the CBOE (equity only) put call ratio zoomed above 1.16 - and I thought last week’s four year high was special!

Hulbert Stock Newsletter Sentiment Index
Mark Hulbert tracks newsletters in general but he also has a sentiment measure based on a sub-set of stock newsletters which time the market. This HSNSI is usually a fantastic contrarian indicator since editors tend to en masse, lose all hope when the market is carving out a bottom. And they tend to be euphoric when the market is about to have the rug pulled from under it.

Although this sentiment measure has been negative for some time, it is now showing real fear. This week it reached -22.5% which means that the average timer is recommending their clients short this market with more than a fifth of their money.

The really bullish significance of this is that in contrast to now, the last time the market was at these levels in mid January, the market timing newsletters were quite nonchalantly looking over the precipice. The fact that they have now soiled their pants (sentiment wise) provides us with a higher probability that the double bottom will hold.

To find a lower sentiment reading from the Hulbert newsletter sentiment index, we’d have to go back all the way to 2005. More specifically, to early May and mid October, 2005 when the market made two important lows:

“Dumb” vs. “Smart” Money
These are two proprietary indicators from Jason Goepfert that amalgamate several sentiment and technical indicators. The “Dumb Money” indicator fell on Friday to 12.5% which means that to find it a friend, we would have to travel all the way back to early 1995 and August 1998. You remember the summer of 1998, right? when we were suffering through the Asian currency and LTCM crisis? …good times, good times.

According to Jason, the gap between the two indicators is also as wide as it has been since 1995 and 1998. Pull up some long term charts and you’ll see the significance of that.

Consumer Sentiment
Although it would usually make big headlines, the results of the Reuters/University of Michigan Surveys of Consumers got buried amid the panic over Bear Stearns today. Consumer sentiment continued to decline to 70.5 - that’s the lowest reading in 16 years!

Like most sentiment measures, this one should also be taken with a spoonful of contrarianism: up is down, down is up. Which means that when consumers are most pessimistic, we have the best opportunity to go long. And when consumers are on average jumping for joy, we have to batten down the hatches.

News Headlines & Covers
Getting your umbrella out will do you no good. We have a torrential downpour of negative news and depressing headlines. To see what I mean, open any news website or newspaper. It is all doom and gloom. This or that hedge fund going belly-up, Bear Stearns pushing up the daisies, the mortgage market collapsing, the credit market in a spasms, consumer sentiment tunneling into the substrata, etc.

Even after the remarkable 90-90 up day we had on Tuesday, the majority are denying that it could potentially have any real bullish portent - although historical precedent says otherwise.

Here are a few recent covers from Business Week: