Trader’s Narrative

It never ceases to amaze me just how horribly wrong regular people are as a group when it comes to timing the market. There is a whole cottage industry around trying to gauge their sentiment so it can be faded.

Being a contrarian isn’t as easy as simply doing the opposite of what the non-professional investors are doing though. The key is to pick your moment. You want to do the opposite of what they are doing only at extreme inflection points.

Escape to Cash
Take for example the current state of Canadian investors. In spite of seeing the market recover, they are so traumatized that cash holdings in Canadian households has climbed 15%. According to the investment banking arm of CIBC, this is the fastest pace since… c’mon now, this shouldn’t be difficult… 2002.

So Canadians are basically rocking back and forth in the fetal position. Just as they were at the bottom of a brutal bear market which cut the Nasdaq in half and decimated investment accounts everywhere.

They have cashed out $35 B of equity mutual funds in the past 6 months. And on a rolling 3 month basis, net sales of mutual funds is in negative territory (in other words, net redemptions). That is the worst state of the mutual fund industry since they have been keeping records.

Double Whammy
So on the one hand we have investors who don’t see the market correction coming, get excited and buy mutual funds. And when the market does correct, and they lose money, they are so shell shocked that they just sit there on a pile of cash while the market moves on.

The 1987 stock market crash lasted two months and panicked investors towards the safety of cash. The problem was that, according to the CIBC report, they stayed there for 16 months afterwards, missing out on an amazing run as the market recovered.

This is the sort of thing that drives regular people absolutely bonkers! The give up saying that the market is “rigged”. Truth is that money flows inevitably from weak hands to strong hands.

The good news in all of this is that with a bit of effort you can learn to zag when everyone else is zigging. This is not as simple as it sounds though. There is something innate within us that draws us to the safety of the crowd. So standing apart is excruciatingly difficult from a mental and emotional basis.

Caution, Caution, Caution
While this level of fear usually marks major market bottoms, it doesn’t mean that the stock market will go up without pause or retracement. In fact, from the percentage of TSX stocks trading above their 50 day moving average, it looks like this is just the right time to lighten up:

The fact that the market is now probably topping here does not negate the contrarian significance of the regular Canadian investor hording cash. Note that the market topped out in July 2007 and again in October 2007 without whipping the masses into a frenzy of stock buying. That is, they weren’t mortgaging their homes to buy stocks like the bubble years gone by.

And when the market bottomed in the summer of 2006 and 2007 it wasn’t enough to cause people to become shell shocked. For some reason it took the market correction in early 2008 for that. I have no idea why. Maybe it was the confluence of the housing market, the price of oil marching higher, the credit crunch, etc. All I know is that right now we have market sentiment so bearish it only appeared last in 2002.

On a related note, if you are interested in mutual fund cash levels and their significance for the stock market, check out Jason Goepfert’s award winning paper: “Mutual Fund Cash Reserves” located in the Charles H. Dow Awards folder of my free trading resource area.

Last Thursday, Barry Ritholtz wrote in The Big Picture about two data points sent in by Doug Kass:

• The cash positions in mutual funds stand at 3.8%, slightly below the 3.9% low established in 1972.

• Margin debt as a percentage of the S&P market cap has climbed to 2.4%, an all-time high. The previous peak? Early 2000, at the height of the Internet bubble.

While Kass is a blisteringly smart guy, his penchant for the bearish side is well known. So to balance things out a bit I’d like to offer a few counter points delivered by Jason Goepfert from SentimenTrader.com

Mutual Fund Cash Positions
Since Goepfert won the 2004 Charles H. Dow award for his paper on mutual fund cash levels, he is a real authority on this topic. To read it, click on the Dow Award folder within the free trading resource box.

According to the paper, we have to normalize the mutual fund cash levels to account for varying interest rates over time. When interest rates are high, mutual fund managers have an incentive to maintain high cash levels because they are compensated for it. So Goepfert models the theoretical cash level for every interest rate point.

However, having normalized cash levels we still find that right now, mutual fund managers are holding about 3.38% less cash than they should be (theoretically for this interest rate level). It may not be that bearish though. For one, if we see a reduction in the Fed rate, it will reset this indicator. Also, a low cash level can be explained by structural changes in the mutual fund industry.

As indexing has grown, it has taken a larger and larger percentage of assets. Since by definition an index can not hold any cash, this can skew the data. But in reality it only reflects a trend towards indexing (and closet indexing).

Another possible explanation is that charters for mutual funds only allow the manager to hold a certain level of cash and in essence, forces them to invest the rest in equities. As well, with the implementation of new technologies, asset managers can now see fund flows in almost real time, allowing them to react quickly to redemptions and not requiring them to have a cash cushion.

To be totally honest though, while valid, these alternative explanations are rather weak. This indicator is quite accurate in the long term and because of that, it does bother me when I see it at such extreme. What Goepfert argues is that it may not be as extreme as it looks.

Margin Debt
When NYSE margin debt overtook the 2000 levels, many bears made a huge deal out of it. However, this data point must not be taken so superficially.

Goepfert points out a little known statistic: apparently the NYSE not only keeps track of how much margin is being used within brokerage accounts but also how much available cash is there. It is important to note that these cash levels exclude the cash generated by short sales - so what is reported is cash that is owned, unrestricted by the account holder.

Interestingly, when we look at cash level, we see that, as a percentage of market capitalization, it is around 16% now. That’s double from 8% at the 2000 bubble top.

The point is that while margin debt relative to market capitalization is high now, investment account holders have in fact much more cash than they did during the top. This represents a huge amount of real buying power that can drive the market much higher as the cash is put to use.

That potential buying power simply was not there seven years ago.

Classic
This is classic Goepfert. He takes what is seemingly obvious, drills to the core, brings data and hard facts to bear and serves up real insight. Most people start out with a conclusion that ‘feels right’ and cling to the factoids that support their position.

I didn’t reproduce the graphs he provides but they are a thing of beauty. To see them, take a 14 day free trial. Trust me, you’ll stick around on day 15.

It doesn’t matter if you’re daytrading or watching the grass grow on your 401k, as long as you’re serious about making money in the market, Jason’s insights are a must.