Trader’s Narrative

As opposed to just a few weeks ago where I had to scrape bits and pieces of information to put together a sentiment overview, this week we have an over abundance of data and indicators, so lets get started:

Hedge Funds Net Short
Based on information from Carpenter Analytical Services, the average hedge fund was just until recently net short to the same degree as mid 2004 and early 2003. I’d suggest taking that with a grain of salt because hedge funds are by their very nature nebulous and non-transparent. Carpenter “reverse engineers” hedge fund positions starting from their performance. While this metric is far from 100% dependable it does provide limited insight into how the brightest traders are positioned.

More important than the snapshot of hedge funds being net short, I’d like to see the market continue to go lower, or level off, while the hedge funds aggressively change their posture and go net long. This is what we saw in mid 2003 just before the S&P 500 took off like a bottle rocket from the bear market depths it had sunk to. On the other hand a dangerous situation brews if the market continues to meander or even manages a feeble rally while hedge funds continue to aggressively bet against it.

Cash Is King
Combined with the net short positions, hedge funds are strangely hiding a significant amount of assets in cash. According to analysts at Citigroup, hedge funds have now socked away $600 billion in cash with $100 billion of that in money market funds. This is highly unusual because assets are invested with hedge funds with the view that they will be invested in the most sophisticated methods allowing for market neutral returns.

The extreme cash position is a sign of temporary uncertainty as the whole market seems to be news driven now. It may also be a result of the new short sale restrictions (although hedge funds can easily circumvent them, it may not be politically expedient to do so). On the plus side, it represents a formidable force that is being kept in reserve, if and when the bull market resumes.

The massive cash horde is also matched by the mutual fund industry with the average equity fund (non-index) holding 5.4% of assets cash. According to Morningstar, this is slightly below the record of 5.5% set in late 2007.

ISEE Sentiment Index
Last week after pointing out that the ISE options sentiment was acting strange, the ratio started this week with a jump to 136 (from a low of 66). As retail option traders rushed to buy call options over put options, the market tumbled down ~1255 (S&P 500 Index). I continue to wait for this indicator to give us a true showing of fear from the retail option traders. We came close last week but with this week’s recovery in the ISE sentiment index, unfortunately, it seems we will have to muddle through until perhaps we see a sharp waterfall decline take us through to real panic.

CBOE Put Call Ratio
This option metric is also showing a muddled picture. As I mentioned briefly last week, the CBOE put call ratio fell to 0.51 but since then it has quickly recovered, as if all the talk of financial Armageddon is simply being ignored by main street investors. This level of complacency is not something that gives a contrarian much confidence that this new found stability in the market holds promise.

Corporate Insiders
From the Vickers Weekly Insider Report, corporate insiders continue to act bullish in the face of the market decline. The ratio of insiders purchase and sale of company stock is as bullish as it was in mid July 2008 and towards the end of the bear market in 2002. Although this is a reliable and quantified indicator (as opposed to bearish or bullish sentiment) it should be projected into an intermediate time frame and not used to make short term trading decisions.

Sentiment Surveys
According to the American Association of Individual Investors (AAII), there is less pessimism this week with only 45.74% bears and slightly higher bulls 34.04% (than last week). I’m not happy to see this because the market is actually lowered than where it closed last week! So to see an uptick (even a small one) in bullish sentiment is disappointing… if one expects this to be the floor for the market.

The Investor’s Intelligence sentiment survey which measures where newsletter editors stand (as judged by ChartCraft) is little changed with 37.5% bulls, 40.9% bears (a slight decrease).

Mark Hulbert, of the Hulbert Financial Digest, suggests that the best performing market timers are significantly more bullish now than their less astute peers. This may seem to be a bullish sign but for the fact that the top performing market timing newsletter editors have been more bullish for most of the market decline. The key, I suspect, is to watch for the deviation between the two camps to widen to a significant enough gap to merit contrarian attention.

Conclusion
The mood is discernibly grumpy on Wall Street. And the financial sector is not the only one to be punished mercilessly. Take for example, Research In Motion (RIMM) which announced earnings that barely managed to disappoint due to slightly higher expectations. Even though they are a profitable company, they were taken behind the shed with a an almost 30% decline in one day!

Having said that, considering the historic and unprecedented situation, it is unusual to not see every single sentiment indicator not stuck at its most extreme reading possible. Arguably, we still have not seen full blown panic selling to completely wash out all the weak hands.

The following is from San Francisco magazine (online). I’ve included it here because, for some odd reason, the original site shows it as a 404 error now. This is much too good to let disappear into the ether, so bookmark this, delicious it or just print it off and read it.

Just remember to not get drunk on the indexing Kool-Aid. All methods of investing are active, even indexes like the Dow Jones. Passivity does not exist. All indexes have their components picked by someone and regularly rebalanced and modified by someone (or some committee).

The best investment advice you’ll never get
For 35 years, Bay Area finance revolutionaries have been pushing a personal investing strategy that brokers despise and hope you ignore. The story of a rebellion that’s slowly but surely putting money into the pockets of millions of Americans, winning powerful converts, and making money managers from California Street to Wall Street squirm.
By Mark Dowie

As Google’s historic August 2004 IPO approached, the company’s senior vice president, Jonathan Rosenberg, realized he was about to spawn hundreds of impetuous young multimillionaires. They would, he feared, become the prey of Wall Street brokers, financial advisers, and wealth managers, all offering their own get-even-richer investment schemes. Scores of them from firms like J.P. Morgan Chase, UBS, Morgan Stanley, and Presidio Financial Partners were already circling company headquarters in Mountain View with hopes of presenting their wares to some soon-to-be-very-wealthy new clients.

Rosenberg didn’t turn the suitors away; he simply placed them in a holding pattern. Then, to protect Google’s staff, he proposed a series of in-house investment teach-ins, to be held before the investment counselors were given a green light to land. Company founders Sergey Brin and Larry Page and CEO Eric Schmidt were excited by the idea and gave it the go-ahead.

Continue reading ‘The Best Investment Advice You’ll Never Get’

Today the venerable Dow Jones Industrial index is undergoing changes to its component stocks: Altria Group, formerly Philip Morris (MO) and Honeywell (HON) are being replaced with Chevron (CVX) and Bank of America (BAC).

Actively Passive
Which explains why I always chuckle when people get into debates about “passive” (aka index) funds vs. “active” funds. As today’s change should evidence, all funds, including indexes are active.

Somebody has to decide: a] what to put into an index b] rebalance it using some formula and c] make changes to the components, from time to time.

In an active fund, those calls are made by the manager who charges a hefty fee and in the case of an index fund like the Dow Jones the decision is made by the editors of The Wall Street Journal. Same difference.

The only real distinction is the portfolio turnover and the MER. While changes to the Dow happen every few years, an actively managed portfolio can have positions traded into and out up to several times a day.

Better Out Than In
Another interesting twist to this debate is that historically, stocks deleted from the Dow Jones end up outperforming the ones that replace them. That goes for not just the Dow but all major indices.

For example, Chevron was in the Dow before until it was deleted on November 1st, 1999 in a swap that involved 3 other boring stocks getting dumped for sexier stocks: Home Depot (HD), Intel (INTC), Microsoft (MSFT) and SBC Communications - now AT&T (T). The editors of the WSJ weren’t immune to the lure of the internet bubble.

The four new stocks went on to produce an average loss of 40% while the deleted and unloved stodgy ones produced an average gain of 27%. So the Dow would have been much better off had there been no changes at all!

The most (in)famous change to the Dow is the elimination of IBM from the index in 1939. While it was eventually added again, according to Norman Fosback, the Dow would now be twice what it is today had there been no change.

Still like indexing? still think it is passive?

Technical Analysis
Rather than a typical technical analysis of the Dow using its own chart, I thought I’d share something a bit more advanced and perhaps more insightful.

The chart below is a ratio of two breadth indicators: the percentage of Dow components above their 50 day moving average, divided by the percentage of Dow components above their 200 day moving average. If it sounds familiar, you’ve probably read this: “Timing the Market with % Above MA Ratios”

Whenever the ratio spikes, the Dow is extremely oversold. The current ratio has spiked because the denominator is 13.33% - the lowest it has been in five years.

Anything in the 2.0+ range is beyond extreme. We’ve only exceeded this level in recent times when the market was making the 2002-2003 bear market bottom.

Fundamental Analysis
According to Morningstar’s fundamental analysis, the Dow is undervalued by 17%. They arrived at this valuation by doing an analysis of each component. They also expect the index to rise 50% in the next 3 years.

According to Jeffrey Ptak, “The Dow hasn’t looked this cheap to us since September 2002 when the index stood at 7,592″. Sound familiar?

The research note was released before today’s changes to the Dow but Morningstar added a note saying that Chevron and Bank of America will actually make the Dow even more undervalued, reducing both trailing and projected price earnings ratio and increasing the dividend yield.

I’m not big on fundamental analysis but when it dovetails so neatly with technical analysis, I can’t help but take notice. Oh and for another take on the general market fundamentals, take a look at the IBES model.

Remember to add your own thinking and due diligence.