Trader’s Narrative

Here is the round up of sentiment data for this week:

Sentiment Surveys
According to the weekly AAII sentiment survey, US retail investors are pretty much split evenly between the bullish and bearish camps. The bulls are at 42% ( that’s a 5% point increase from last week) while the bears are at 40% (4% point decrease from last week).

ChartCraft’s Investor Intelligence measure of stock newsletter editors has taken the bullish mantle from the retail investor’s survey for several weeks now. And it continues this week as well. The latest II poll shows the bulls commanding a 47.8% share of the respondents (down slightly from last week) and the bulls, 24.4%. The simple bear/bull ratio continues to run at about 2:1 - giving contrarians a clear signal.

German ZEW Survey of Investor Confidence
Turning our attention to the other side of the pond, the German ZEW sentiment survey of investor confidence (green line in chart below) came in slighly short of the 60 expectation but still managed to climb to 57.7 - its most bullish level since April 2006. However, the survey’s “current economic” outlook - while slightly off its recent lows - is still mired at historic depths (blue line):

This month’s survey results mark one of the few times in the history of this statistic where there is a large mismatch between the two measures. While the current economic situation is still deemed to be very poor, confidence in the future is very high. This should be familiar as it is the same tune that everyone is humming in the US markets. The question then is what happens if the rosy expectations of the future do not come about?

Option Traders
Both the CBOE put call ratio and the ISEE index are showing an excessive bullishness. This should be normal but since they have disagreed with one another so much, it made me sit up and take notice.

The CBOE put call ratio (equity only) dropped to a low of 0.45 earlier in the week (Wednesday - September 16th, 2009). That’s a lot of call buying! The short term moving average of the daily put call ratio continued to decline as it has for the past few months. It is already below its long term channel so it is difficult to determine what if any sort of signal it is giving now.

The ISEE index (equity only) meanwhile jumped to 242 on Wednesday’s long range candlestick. That means for every 100 puts, 242 calls were bought (to initiate a position). To find a more bullish one day statistic, we’d have to hop into our time machine and travel back to November 6th, 2007 when the ISEE index hit 245. At that time the S&P 500 was trading around the 1500 level. More important than just the one day spike, the 10 day moving average for the ISEE is now also significantly high as shown on the chart below:
Continue reading ‘Sentiment Overview: Week Of September 18th, 2009′

Sentiment Surveys
According to Investor’s Intelligence newsletter publishers are as gloomy as they have ever been. This week’s sentiment bearish sentiment was 54.4% with bullish newsletter editors unchanged. While slightly more than half may not seem like much, you have to understand that like most media outlets, newsletters have a positivity bias that skews readings. But keep in mind that the II measure is not completely quantitative.

The American Association of Individual Investor’s (AAII) sentiment survey in contrast continues to show that retail investors in the US have suddenly become very bold. Similar to last week’s sentiment the optimists and pessimists are both 38.74%. This apathy or lack of fear is strange and more than a little unnerving.

Volatility
Volatility continued to climb to the astonishment of everyone (first and foremost yours truly). The CBOE VIX index spiked to 89.3 and settled down to “only” 79.1 - quick someone give me a synonym for un-fraking-believable. Looking at the VIX futures market, the “smart” money, or commercial hedgers are carrying the largest long position they have ever been since the contract started. While the retail traders are taking the other side of the trade.

Options
The options market yawned as usual. I prefer the CBOE equity only put call ratio because it filters out the noise. Although it rose, it didn’t even manage to reach 1.0 - it should easily be above 1.5 considering what we are going through. I tried to explain this crazy options market. But I’m not sure if I even convinced myself. This, like the majority of what is going on, is a head scratcher.

Fund Flows
As you can imagine, mutual funds have been hemorrhaging assets as people either sell to stuff cash under the mattress or take the slightly less safe road and buy money market funds. But preliminary numbers for the most recent fund flows shows a slight inflow. Again, this is puzzling. From a contrarian point of view, the ideal condition would be a continued outflow trend, even if the market rallied or stabilized - which it hasn’t really done.

What I’m still waiting for is the tsunami of hedge funds redemptions. Usually hedge funds have a lock up period to give the manager some breathing room. The more exclusive the hedge fund, the longer the lockup but usually it is 2-3 months.

Lowry’s 90-90 vs. Selling Pressure
As the VIX indicates this is an unbelievably volatile market. We’ve had so many 90-90 days (or very close calls) that my head is spinning. On Friday 84% of volume on the NYSE was negative. On Tuesday (October 21st) we saw almost the opposite with 87% flowing to stocks trading up.

Paul Desmond’s research at Lowry’s into the efficacy of 90-90 days has permeated the trading and investing world so much that I fear it may jump the shark. But assuming that it hasn’t already, there is more to the market than just watching for these important days. Lowry’s itself calculates two aggregate indicators for the market’s health: buying and selling pressure. Right now selling pressure has the upper hand (after jumping to an extreme level). Until it subsides and buying pressure takes over, the market isn’t going to go up.

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.

Money tends to get shuffled around from place to place and hand to hand.

Within the financial markets the big three boxes are stocks, bonds and cash. When the bets are placed, over time, the retail traders tend to lose and the deep pocketed, well informed institutional traders tend to win.

So by looking at where the retail traders are placing their bets, we can get an idea of where to not place ours.

AAII Allocation Data
The American Association of Individual Investors (AAII) is famous among those who track sentiment for their weekly survey. But they also keep track of several other key data points. Among them is the allocation ratio of their members between cash, bonds and stocks.

From the latest data, AAII respondents have said that they have increased their cash positions to almost a third of their portfolio value. This is the highest cash levels since late 2005 and 2002. To raise the cash allocation, retail investors have sold their equity holdings.

In comparison to the summer of 2007 when the allocation for equities was almost 70%, today it is just above 50%. To find similar levels we’d have to go back to November 2005, summer of 2002 and May of 2003. Each of those instances were great buy points with a long-term time horizon.

But remember, this is as reported by the membership of the AAII. There is no way for them to verify if indeed what their members are reporting about their allocations is true. So let’s take a look at actual fund flow data.

Fund Flows Data
According to AMD Data, July’s money market funds reports net cash inflows totaling $44.402 billion! That is a very large amount for one month.

Back in April, I pointed out the reverse: a massive exodus from money market funds to the tune of almost $80 billion. Since then the average mutual fund investor has consistently increased their cash position - which would tend to lend credence to the AAII survey results.

Caveat Trader!
The market always throws curve-balls to keep things unpredictable and exciting. So remember, retail traders are not always wrong.

Here is the lay of the sentiment land for the week:

Barron’s Institutional Survey
According to the latest Barron’s “Big Money Poll”, the professional investors are fairly bullish but not excited about stocks (see graph). But the majority, 55%, believe the market to be undervalued.

And 87% say they see themselves as buyers within 3-6 months. The remaining 13% see themselves as seller in that time frame.

AAII Sentiment Survey
The American Association of Individual Investors sentiment survey continues to be problematic for bulls. From a contrarian point of view, the ideal is if sentiment remains unchanged or even falls in the face of a market rally. What we are seeing however is the opposite. As the market has recovered, the AAII sentiment survey has shown an alarming increase in bulls.

I mentioned this last week in the sentiment overview and unfortunately, things have gotten slightly worse. Now only 26% of AAII respondents are bearish and 53% are bullish. There is no way we can discount or ignore this. Such a high level of bullishness is downright frightening - from a contrarian point of view. The last time we had this many bulls in the AAII was in October 2007 when the market put in its swing high.

I’ve been also noticing technical indicators also pop up showing a potential for the recovery to stall. So while in the short term we might be in for some turbulence or even a set back, I still think there are enough things in place for a protracted bull market.

Fund Flows

According to AMG Data, for the first 3 months of 2008 equity funds had a net outflow of $29.7 B - including ETFs. Domestic funds had an outflow of $22.5 B.

By March the panic was apparently over and mutual funds and ETFs once again had net inflows: $14.7 B for the month. Net outflows during corrections tells me that the retail investor isn’t stubbornly clinging to hope. But selling in fear that things will get worse. But in the end, the market needs inflows to be able to power ahead.

When you combine the healthy return of inflows to mutual funds and ETFs with the limited supply of securities due to a lack of IPOs, and secondaries as well as the further restriction of supply through continuous buy-back programs, you have the right setting for a powerful bull market.

Warren Buffett: “worst is over”
The Sage of Omaha believes that “the worst of the crisis in Wall Street is over”. In an interview he said that he supported the Bear Stearns buyout because there was a real risk of contagion had it fallen. He also thinks “the Fed did the right thing” by stepping in and acting as a direct lender to the financial companies in need. Of course, this is little consolation to those who are being squeezed by the mortgage crisis but from a trading or investment point of view, it is nice to have someone like Buffett confirm that Armageddon was averted. At the same time, Buffet - unlike Richard Russell - is not a raging bull. He thinks that we will see moderate future growth, much less than in the past decades.

PVA Valuation
This isn’t really sentiment, as such, but I include it because it dovetailed nicely with Barron’s poll results where most respondents believe the stock market to be undervalued.

Ford Equity Research uses a proprietary measure to determine valuation for a company. They take the market price of the company’s stock and divide by value, derived from “a proprietary intrinsic value model”. According to Ford, 40% of the almost 1,800 US stocks it tracks are undervalued.

This, by itself, wouldn’t mean much except that this measure has an enviable track record. The previous times that it showed a higher percentage of stocks undervalued was at the end of 2002, as the bear market ended, with 48% of the stock universe undervalued. The second instance when there were more than 40% of stocks undervalued was in 1998, during the Asian financial crisis (also known as the LTCM debacle).