Trader’s Narrative

Yesterday we looked at the strange behavior of US mutual fund holders in shunning equities and stampeding into bond funds. That lead to lively discussion with different comments on what this means. Leaving aside the various arguments on whether this is a good or bad omen for the stock market, let’s explore the US retail investor’s sudden love for bonds.

We’ve just woken up to the realization that we have our own “lost decade” for stocks. From 1999 to 2009 the worst asset class you could have chosen would have been equities. In contrast Treasury bonds returned 110%, second only to gold.

But similar to the importance of timing the stock market, when you purchase bonds is pivotal to success. While we use metrics like P/E ratios or price dividend ratios to gauge the stock market, the bond market is much simpler. According to a study by Vanguard, all we have to do is look at the current yield. If it is low, the future returns will be similarly low. If high, then future returns from bonds will also be high.

You can download the report from the Free Trading Resource section (Reports & Articles folder: “The Historical Impact and Future Implications of Extraordinary Markets”). Here is how they explain their historical study:

…we put the historical yield levels for the 10-year constant-maturity Treasury bond into quintiles and show the range of returns over the next 10 years for those initial yield levels. For example, with an initial yield between 7.8% and 14.0% (quintile 1), the subsequent 10-year returns have been between 6.6% and 12.3% per year. Intuitively, these high returns stem from the fact that higher initial yield levels have been followed by systematically declining interest rates over the subsequent 10 years.

Here’s the resulting chart:

In late 2008, during the darkest days of the financial crisis, the 10 year Treasury bond yields sunk to 2.2% (5th quintile). The current yield on the 10 year is 3.44% which puts it in the 4th quintile. Based on historical data (from January 1928 to December 2008) the median return for the decade ahead is only 3.2%. And if you really want to get technical, you would subtract a reasonable inflation rate - say 2%? - which would bring the return to almost zip.

This study proves what we all know intuitively. Current rates are extremely low and the probability is therefore skewed towards rising rates, which means lower future returns. The higher the rates rise, the lower that return. So if you really believe in the inflation boogey man, you would be actually avoiding bonds not running into their arms as the average US retail investor is doing right now.

Instead of buying bonds, if you expect runaway inflation, you should be buying Treasury inflation-protected securities (TIPS) - bonds whose coupon increases along with inflation, and decreases with deflation.

A surprising number of retail investors are doing exactly that right now. Here’s an excerpt from a recent article from the Wall St. Journal:

Richard Seelig, a retired high-school math teacher in Pelham, Mass., bought shares of the iShares Barclays TIPS Bond Fund last December for his Roth individual retirement account. “I looked at the amount of money the government was spending that it didn’t have, and I thought, well, that is going to come back to haunt us,” he says.

But we are not in an inflationary environment right now. The yield gap between TIPS and normal Treasuries is 1.8% implying that that is the inflation rate in the US right now. But that may be deceptive for two reasons. Everything we’re seeing right now in terms of economic measures is signaling strong deflationary pressures. And two, the strong retail demand for TIPS has pushed their prices higher.

Even as retail investors rush to put their money into TIPS, there is no guarantee that they will see a payoff. This is because as inflation is sighted by the Federal Reserve, they will raise interest rates. And as interest rates rise, the value of bonds will decline.

So current buyers of TIPS are not only betting that inflation will be higher than 1.8% in the future, they are also betting that the Federal Reserve will be a pushover. That assumption may come back to haunt them.

If the above arguments are not persuasive, here’s another. Based on the historical data for US bonds, Prof. Jeremy Siegel has plotted a cumulative return for this asset class over the very long term (chart to the left). Total bond returns move in slow, multi-decade arches swinging above and then below a regression line (red). Right now, the cumulative return for bonds is extremely high relative to their historical trend. A reversion to the mean will happen. The only question is when and how fast. For more information on this valuation approach, see this article from MarketWatch.

Two Wrongs
If the shunning of equity funds by US mutual fund investors is bullish in your opinion due to contrarian analysis. Then it is difficult to not be labeled a hypocrite if you also believe in a future inflationary Armageddon. Either the “dumb money” retail investor is wrong in disbelieving the equity bull market, or they are wrong in expecting inflation.

While I completely understand and empathize with the traumatized psychological state of the average US retail investor, tragically, it looks as if they are jumping from the frying pan into the fire.

Last week we looked at the levels of cash and free credits being held in institutional and retail trading accounts in the US: Mutual Fund Cash Levels & NYSE Free Credits. I briefly touched on a research report on mutual fund cash levels by Jason Goepfert, who by the way, runs a great service at SentimenTrader. However, I wrote that:

Unfortunately, Goepfert’s research report does not take into consideration inflation or deflation but simply adjusts the level of mutual fund cash levels according to the 90 day T-Bill rate. I’ve sent him a message about this so hopefully when he’s back from vacation he can update it with this new twist thrown in.

Upon his return, Jason accepted my suggestion and lost no time in whipping up a new indicator which takes into account the added variable of inflation/deflation.

To be able to understand what this new chart is saying, it is helpful to go back to the award winning research report. In it, Jason argues that before we try to use mutual fund cash levels as an indicator, we need to adjust it for the prevailing interest rate environment. For example, in the 1980’s, with interest rates in the double digits, there was ample reward for sitting in cash. Stripping out this effect, therefore, is important because otherwise it is a distortion.

Using statistical modeling, we can determine how much cash should be held by assuming a certain level of interest (90 day T-Bill rate). After that, it is easy to compare the actual cash levels to this theoretical level to determine if mutual funds are overweight or underweight cash. Looked at this way, mutual fund cash levels are neutral, telling us that managers are neither overweight or underweight cash right now.

Alright, so what happens when we also take into account the effect of inflation or in today’s case deflation? In other words, the real rate of interest?

A completely different picture emerges. This isn’t surprising because we are currently experiencing real interest rates close to +6.5% - a far cry from the nominal rate of 90 day T-bills. Here is the inflation/deflation adjusted chart of mutual fund cash levels:
Continue reading ‘Mutual Fund Cash Levels Adjusted For Inflation’

Here’s the sentiment summary for this week’s trading:

Sentiment Surveys
According to the sentiment surveys, an alarming number of investors and market timers have returned to the long side. The weekly AAII retail investor sentiment survey shows 48% bulls (an increase of 8% points) and 37% bears (a decrease of 12% points). We haven’t seen this many bulls in the AAII survey since the first week of the year. As I’m sure you’ll recall, that was not a happy time for putting new money to work on the long side.

According to ChartCraft, the weekly Investors Intelligence newsletter sentiment survey shows 42.5% bulls and 25.3% bears. The S&P 500 ended the week 21 points higher (or 2.2%) so the market hasn’t really done anything to deserve such hope or devotion.

Barclays Capital Sentiment Survey
Barclays Capital said that only 17.5% of the 605 respondents to its quarterly sentiment survey believe that ‘risky assets’ have more room to rise. Those taking part in the survey were central banks, asset managers and hedge funds. The majority believe that the world economy will experience either a protracted slowdown or if it is in recovery now, it will falter once more (a “W” shaped recovery). Asked whether the spring rally was just a “bear market rally”, 60% agreed - indicating that there is still a lot of dry powder out there.

NAAIM
Along with most sentiment measures the NAAIM trend survey of managers has recovered since the spring lows. For more information on the metric check out: NAAIM Sentiment Survey.

Market Froth
We’ve seen a lightning fast return of speculative trading to the stock market. You can see it in the volume of ‘garbage’ stocks (trading below $5/share) and in the general willingness of most people to shrug off the dark foreboding sense they harbored just a few months ago that the end was nigh.

There is also mounting evidence from the Rydex fund flows that the trigger happy traders that use these securities to time the market are piling into the long side. This is the case for both leveraged and normal Rydex funds and has in the past marked either significant market tops or the start of a plateau. In either case, when there is so much lopsided optimism in Rydex mutual funds, it is a flashing red light for those long the market.

Magazine Cover
I have a gut feeling that this week’s Economist magazine cover should be framed somewhere for posterity. It is a graphic showing a Tyrannosaurus Rex made up of car parts, leaking oil (as if bleeding).

I can’t help but wonder, if by the time a magazine puts up something like this, have the auto industry sector reached a nadir?

And I’m not thinking that because the image is hyperbole but because it is a creative representation of the unvarnished truth. I’d prefer if it was on Newsweek or Time but we’ll see. I think this Economist cover is one we’ll come back to years from now.

Here is the summary of sentiment data for this past week:

Earnings Season
We are about to enter the heaviest weeks of earnings season, with some nasty surprises, so buckle up!

Sentiment Surveys
The weekly AAII sentiment survey reflects 36% as bears (a decline of -8% points from last week) and 44% bulls (a rise of 8% points). Not surprisingly, the rally is continuing to send positive ripples through retail traders.

ChartCraft’s Investors Intelligence survey of stock newsletter editors this week shows the most bullish posture since the start of this bear market (that is, assuming we’re still in it). With this week’s results, the optimists outnumber the pessimists for the the first time since January 2nd, 2009. Previous to that, it was in mid August 2008 and before that, a period of time from mid April to June 2008. All of those times coincide with market tops.

According to the Hulbert Stock Newsletter Sentiment Index (HSNSI), which measures sentiment among short-term market timing newsletter editors, while the market has spent the past 2 weeks treading water, newsletter editors are much more bullish. Two weeks ago they were suggesting to their readers an average long position of only 8.8% but now, that’s jumped almost 18% points to 26.5%. It isn’t the nominal value of the sentiment but the fact that there has been a remarkable increase in bullishness with no real market movement to provide a rational cause for it.

NFIB
It wasn’t that long ago when the National Federation of Independent Business (NFIB) Small Business Optimism Index fell to a new low. In April it once again set a record, falling to 81. Small businesses across America are continuing to retrench - no green shoots in sight!

Option Sentiment
Earlier in the week I outlined how the option traders are pushing their luck. Follow that link to get more details. During the rest of the week they continued to press their luck. The ISE sentiment index, tracking the retail options trader spent 3 consecutive days above 200 - meaning that they bought twice as many calls to open a trade as puts this week. The last time that we saw this many consecutive days of bullishness was in late December 2007 when the S&P 500 was trading at ~1475. The last time before that when the ISE sentiment index hovered over the 200 level for 3 or more consecutive days was in late October 2007 - when the market had just begun this brutal bear market. With odds like that, the rally is on very weak legs.

In confirmation, the CBOE put call ratio continues to hover around the mid-point (equity only data). This ratio ended the week at 0.56 - meaning that the option traders were buying almost twice as many calls to puts.

Fund Flows
Similar to the twitchy Rydex market timers, who are all of a sudden very bullish now, the typical US equity mutual fund buyer has finally returned to the market. Early fund flow data for the short term, weekly data, indicates that we are seeing tentative but clearly net positive inflows into US equity mutual funds. Of course, we can’t play a contrarian at all times. The stock market needs this capital injection - especially considering the gargantuan amount of scared money sitting on the sideline. But in the past, whenever these market participants have peeked out from under their covers and dared to re-enter the market, they’ve had their head handed to them. The most recent example was the new year top (January 2009).

NAAIM Survey
Although it slipped mention, the National Association of Active Investment Managers (NAAIM) sentiment survey was an emaciated 2.15 on March 4th, 2009, just days before the launch of this latest rally. Although I didn’t mention it at the time, I’m not sure if it is meaningful because in the short history of this sentiment indicator, there are two weeks with a more bearish outlook: July 9th, 2008 (2.03) and October 8th, 2008 (-2.97) and neither of them really resulted in much of a rally. In July, the S&P 500 went sideways and eventually wilted and in October the market thrashed about but quickly melted even lower. While I continue to monitor lesser known indicators like the AAIM, I’m not totally convinced that it has proven itself to deserve our full attention.

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Investors Intelligence
On Tuesday, just as the market was poised for its rocket ride higher, ChartCraft’s Investors Intelligence survey of stock newsletter editor’s sentiment showed 26.4% leaning bullish and 47.2% bearish. That’s a pretty good level of pessimism but not nearly as much as we saw late last year when bearish respondents came in at around 55%. It will be interesting to watch next week’s numbers to see if there is a continued collapse in hope or whether the market’s recent bounce causes people to jump on the bandwagon again (as they have repeatedly during this bear market).

AAII
After last week’s historic AAII sentiment survey results, it isn’t surprising to see some push back. The bearish camp shrunk by 15% points to 55%. That’s still very high but no contrarian likes to see such a the sudden move in response to the rally we saw. The optimists rose 9 percentage points higher from last week to 28%. The survey was taken on March 12th, after Tuesday’s massive one day rally. Real capitulation would have been either a more timid move towards optimism or continued slide into further pessimism.

Options Sentiment
The options market continues to behave very strangely. After the spike high in the ISE sentiment, that option ratio calmed down a bit but it is still showing an elevated level of call purchases (compared to puts).

The CBOE (equity only) put call ratio concurs with a very low reading for the whole week. The averages (10 and 50 simple day moving average) are both stuck in the middle, not providing any real signal.

OTC Volume
One measure of investor optimism is the activity in the “over the counter” market. Since it has less regulation and oversight, as well as smaller, riskier securities, it is a good barometer of investor sentiment. In the past, extremes of activity in the OTC market have marked the “blow off” stage. In a hurricane even turkeys can fly and in a bull market, the highest flyers are often the lowest quality OTC stocks. Right now the level of activity in the OTC market is extremely low. Lower than the 2002-2003 bear market low, lower than the 1998 crisis low. The lowest in at least a decade, in fact. If OTC activity had an EKG, it would have flat-lined. Which is good in a sense because it shows that we have wrung out every single drop of excessive speculative energy (at least in this corner of the market).

Insider Buying
Corporate insiders continue to pour money into their own companies stocks with renewed vigor. We are now approaching the level of buying frenzy that we last saw in late November 2008. Although these are generally viewed as the “smart money” crowd, over this bear market, they have not shown the usual agility in timing the bottom. If the market continues to rally, they will have finally been proven right.

Mutual Fund Cash
The cash buildup in mutual fund portfolios continues. The estimate now is that almost 6% of the average equity mutual fund portfolio is made up of cash or equivalents. We need to “normalize” that to take into account different monetary conditions over time (see previous mention for more info).

We are now approaching the equivalent of the mid-1990’s for normalized cash holdings. This isn’t the extreme that we saw, for example, in the mid 1970’s or the early 1990’s. Both of those times coincide with a massive buildup of cash and a lasting market bottom. However, today’s level is enough to stoke a bull market - assuming the other ingredients are also there.

This could be caused by the general pessimism pervading Wall Street right now. And it could also be that the average fund manager’s hand is forced by the unforgiving onslaught of mutual fund redemptions. The fund flow data certainly shows that the average retail mutual fund owner has had enough and is cashing in (possibly at the bottom or close to it).

Magazine Cover
This week’s magazine cover indicator comes courtesy of The Economist: