Trader’s Narrative

Here is this week’s sentiment round-up:

The AAII weekly sentiment survey shows that the consensus reversed suddenly from the giddily bullish extreme that we saw last week. The bulls fell to 37%, a decline of 17% points. And the bears increased to 40% coming to an almost perfect equilibrium.

While this is a dramatic decrease in their level of optimism, I’m still cautious. The last time we had the same level of bullishness in the AAII survey was in early May 2008. And as I mentioned during last week’s sentiment overview, the stock market didn’t roll over immediately in response. The S&P 500 actually climbed slightly higher in the following weeks. So just because the market has overtaken last week’s highs does not absolve it from a potentially mortal weakness.

The average exposure recommended by stock newsletter editors (as measured by the Hulbert Stock Newsletter Sentiment Index) fell to 30.3% - that’s a sharp decline of 17% points from just 7 days ago. From a contrarian point of view, if the level of bearishness continues to rise even as the stock market rises, then it would imply that this rally still has some life left in it. But we aren’t there yet.

This week’s Investors Intelligence survey was little changed from last week: the bulls were at 48.3% and the bears at 23.1%. This is the only sentiment survey that is dancing to its own tune.

According to the AAII asset allocation survey equity allocation has reached 57% - a level last seen before the equity markets started their cascade down last year.

We touched briefly on the bond allocation at the beginning of the month. At 25% (a 9% point jump!) it is not only the single largest increase but also brings bonds to the highest chunk of the AAII portfolio it has ever been since 1987 when they started keeping track.

Finally, to round off, retail investors are finally feeling comfortable enough to leave the safety of cash. After the cash portion of their model portfolio reached a peak of 45% earlier this year, it is now down to just 25%. As I’ve mentioned before, there is a massive pile of cash sitting on the sidelines and it is slowly being deployed. Of course not all of it is ending up in the equity market, but considering the size of the build-up, even a small portion can have a significant effect.

The NDR Crowd Sentiment Poll is a proprietary sentiment measure from Ned Davis Research. It surpassed its extreme level (61.5) last week. Since then however it has backed off from this threshold and is now 4.3 points lower to 59.1 - this is similar to the other sentiment surveys covered above.

Fund Manager Survey
According to a Merrill Lynch survey of 204 fund managers, managing a total of $554 billion, 75% believe that the global economy will improve in the next 12 months. That is the highest level of optimism since November 2003. A smaller amount (70%) expect corporate profits to rise in the coming year.

Fund managers are putting money where their mouth. They have reduced their cash levels from an average of 4.7% in July to 3.5% in August - the lowest level since July 2007. They have also increased their allocation to equities sharply from last month. Merrill Lynch’s Risk and Liquidity Indicator, which measures risk appetites is at a 2 year high.

This dovetails nicely with what we are seeing from the AAII model portfolio allocation (above). The build up of cash was a sudden, fear induced spike. But the unwinding of it is more orderly as a gradual stream of investors decide that it is safe to venture out once more and take risks again.

Option Traders
The CBOE (equity only) put call ratio continues to fall as optimistic traders prefer calls to puts. Friday it closed at 0.51 meaning that traders were trading twice as many calls as puts. The simple 20 day average of this ratio is now at 0.587 - the lowest since June 2007:

Perhaps more importantly, the short term moving average has as a result, broken well below the multi-year rising channel that contained the put call ratio (red arrow).

The lesser known ISE sentiment index (equity only) reached a high of 202 on Friday. Being a call put ratio, this means that for every 100 puts, there were 202 calls being bought. But the short term moving average of this indicator is still treading water and not at an extreme.

Magazine Cover Indicator
Here is the August cover for Futures - a magazine dedicated to news and analysis of options, futures and stock trading. It is not a general interest magazine like Newsweek or even Business Week so I’m not sure how much contrarian weight we can put on it.

In any case, the image is of a hazy outline of a bull appearing in the distance. The implied question is, “It might be, it could be, is it?” meaning a bull market. Obviously this is the question that many are grappling with.

The interesting aspect of this cover is that it is not boldly trumpeting the arrival of a new bull market but instead timidly asking if it might be, could be true. And finally, wondering if it truly is.

By the way, if you have a US mailing address, for a limited time you can get a free subscription to Futures Magazine. I’m not sure how long this special offer will last so sign up right now.

Consumer Confidence
The preliminary Consumer Confidence survey from Reuters/University of Michigan showed a surprising decline to 63.2 for August - back to a level not seen since March 2009 when the market hit its trough. It would seem that the US consumer is being buffeted with the cross winds of deflation, which make things more affordable, rising unemployment and a schizophrenic stock market. No wonder then that they can’t seem to make up their mind:

A quick summary of all things sentiment-wise for the stock market this past week:

Sentiment Surveys
The mind set of the retail investors as measured by the weekly AAII sentiment survey shows little change. We had an increase of 7% points for the bearish camp to 46% and a decline of 6% points for the bulls to 33%. Which is not very helpful as it leaves us mired in “no man’s land” - exactly where we’ve been for the past few months.

In contrast, the Investors Intelligence weekly survey of newsletter editors continues to be dominated by optimism. This week we had a small reduction in the bullish camp to 44.8% and a small increase in the bearish camp to 26.4%.

Bond Bears
For what is happening in terms of sentiment in bonds, check out the post from a few days ago: bond sentiment.

Options Sentiment
CBOE put call equity ratio: We got a slight ‘blip’ on Thursday (June 17th 2009) when this ratio hit 0.88. That’s not even close to a level which would get any contrarian excited. But it is the highest level of fear shown in this indicator since early March 2009. Keep in mind though that this trusty indicator has been firing blanks throughout this bear market.

ISEE Sentiment index: the equity only call put option ratio from the ISE reached a low this week we haven’t seen since November 2008. Remember, this is inverse to the usual put call ratio so a large number denotes optimism and a low number fear. On Thursday the ISEE Sentiment index reached 92 (meaning 92 calls purchased for every 100 puts purchased to open a retail options position).

This dovetails with the technical indicators that are also showing a very short term oversold condition in the market. The key is how the market reacts as a result: will it use it to bounce strongly higher? or collapse lower in spite of it?

Secondary Market
The doors of the IPO market have been shut tight for many months now. And although we are seeing the door budge open again slightly, the real action has been in the secondary market.

According to TrimTabs, last month saw a record shattering $64 billion dollars of IPO and secondary market offerings combined. To put that in perspective the previous monthly record was just $38 billion. While TrimTabs didn’t provide a sector breakdown, I suspect that most if not the vast majority of the record issuance was in the financial sector.

Historically, there is an inverse relationship between the primary and secondary market activity and forward market performance. This isn’t surprising since at the heart of the market, once you remove all the noise, is a simple supply and demand equation. There are a finite number of dollars chasing a finite number of shares. If you tip the balance in one direction, the market will react eventually.

According to two methods of analysis (from TrimTabs and Ned Davis Research) we are seeing a historical extreme that has only been seen before quite rarely. For more details, check out this article by Mark Hulbert. My only criticism of this analysis is that they use nominal numbers instead of ratios.

Since the market generally rises over time (recent history excluded), it isn’t helpful to compare the secondary market in say 1998 in dollar terms to that of today. The way we can equalize it is to look at the ratio of the secondary market to the total market (for example, the total equity value of the S&P 500). In this way we can easily compare across decades and get a more accurate idea.

This criticism notwithstanding, since the other extreme readings come from relatively recent years (2000, 2008, etc.) we can conclude that a ratio analysis would yield little improvement. The conclusion stands that Wall Street is suddenly awash in ‘paper’. I’m sure some will come up with conspiracy theories of this spring rally being rigged to allow for the recapitalization of the ailing US banks. But remember what Ben Graham said about the stock market: “In the short run it’s a voting machine, but in the long run it’s a weighing machine.”

The prediction markets and the polls were correct. Barack Obama is the next president of the United States of America. As a quick aside, America please accept my hearty appreciation and congratulations for your choice. If you listened carefully, just before the thunderous celebration across the globe, you heard a sigh of relief.

Putting aside today’s market slide of 5%, the important question is what does Wall Street prefer? a Democrat or Republican in the White House? Republicans’ reputation is of being more capitalist and business friendly, and the Democrats of being “tax and spend” as well as more prone to regulation. But just like the myth of gold as a safe-haven, the facts do not support this assumption.

Here is a chart showing different historical returns for the stock market under different administrations (source: Federal Reserve Bank of San Francisco).

The biggest outliers in recent history are, of course, Coolidge who’s presidency oversaw the 1925-1929 bubble and Hoover, who presided over the bust that followed. But even if we ignore these or by extension of the time horizon, go back far enough, the relationship still holds: Democratic presidents coincide with much higher stock market returns.

Another study that looked at the relationship between politics and investment returns was by Pedro Santa-Clara and Rossen Valkanov. Their paper titled “The Presidential Puzzle: Political Cycles and the Stock Market” was published in The Journal of Finance in October 2003. In it they show that during Democratic governments, the US stock market (between 1927 - 1998) provides an excess return of 10.69% above the 3 month Treasury Bill rates. While Republican presidents provide an excess return of 1.69% over and above 3 month Treasury bill rates.

According to Ned Davis Research the S&P 500 Index performs poorest in the first year of the four-year election cycle. Since 1900, the stock market does best in the pre-election year (11.3%) and the election year itself (9.5%). The pre-election year didn’t live up to its historic pattern - to say the least!

Here is a recent visualization from the New York Times, showing 80 years of market returns:

Source: New York Times

If you aren’t satisfied with this myth being upended, here is an interesting tool that lets you make different assumptions about the stock market returns under different administrations. For example, you can check what would happen if we include dividend reinvestment. Or what about the effects of inflation? And time lag for policy effects? You get the idea.

President-Elect Barack Obama
In case you didn’t catch it, here is Obama’s victory speech (putting Cicero to shame).

Here are some thoughts with my own conclusions at the end:

Ned Davis Research
A very respected institutional research house, Ned Davis’ company relies on 12 indicators covering sentiment, volume, volatility, and breadth. Right now ten are flashing a cyclical buy signal. But a unanimous result isn’t needed for it to be valid. For example, in the bear market bottom of 2002, only nine of Ned Davis Research’s indicators was indicating a buy. But they are not recommending to their institutional clients to start buying. They want to be patient and wait for a retest of the lows. If market internals are healthy on such a retest, then they would suggest going long.

Stock Market Cycle
There are patterns in the market’s history. But so far this year, the market has forged its own path. An election year should be a positive for market returns, especially in the later months of the year. But not this year.

The four year stock market cycle means that 2010 is the year to watch. But according to the decennial cycle, the 8th year in a decade has been good historically. Unless we have a miracle, this year will also be an exception. Here is the master of market cycles, Peter Eliades offering his views:

Credit Squeeze Relaxing
Both the TED spread and the LIBOR rate have receded. As well the price of “insurance” on default for banks has also dropped. There are mounting signs that we are seeing a thaw in the credit freeze that paralyzed the market. My only quibble is the short term rate (90 T-Bill rate) which continues to be pushed down. The bond market is telling the Fed to lower rates. Hopefully they will listen (unlike all the previous times) and get ahead of the situation rather than playing catch up.

Volatilitius Maximus
Volatility has been absolutely insane. There is no gentler way to put it. We’re seeing double digit (or close) moves in the market daily. It is both unnerving and exciting. And here I’m not just referring to the sky high VIX index but also to the breadth numbers which show extremes. The good news may be that such volatility has been historically associated with market bottoms. As I wrote two years ago, extremes in market breadth with the advance decline numbers swinging from one extreme to the other to gather “fuel” for a sustainable trend to be established:

Smart Money vs. Dumb Money
At every inflection point in the market, we witness the smart money and the dumb money do different things. This is how wealth is transferred from one group to the other after all. So far we’ve seen Warren Buffett extract very favorable terms with General Electric (GE) and Goldman Sachs (GS). Terms that the US government hasn’t gotten. That’s another issue though. Although you or I may not be able to negotiate the same terms, it is still valuable to watch what the smart money is doing.

Which reminds me of Tony Oz’s video where he called a bottom. Faced with a melt-up, he did what any smart trader would do, sell into the wave of buying.

Corporate insiders are also considered “smart money” and they have accelerated the rate of their purchases, pushing the buy-sell ratio to 2:1. This is very unusual because usually it is the other way around as insiders sell shares which are given to them as part of their compensation package. But caution is warranted because insiders are notorious for being early to the party - as much as one whole year.

The other end of this see saw is to watch the “dumb money”. I’ve gone into detail over the past sentiment overview regarding the public’s and retail investor’s pessimism during this crisis so I won’t rehash it here. Now that we are getting the first glimpses of the bulls returning, the most important aspect of contrarian sentiment comes into play; watching how the “dumb money” reacts to a recovery in the markets. If they continue to be fearful and pessimistic, even when the market recovers, then the chance that it is a real floor is much higher. But if they quickly switch sides, then we will see more downside.

Conclusion
My own hunch based on all of the above and more, is that this is a cyclical bottom. It is tradeable, and the volatility provides amazing short term opportunities for trigger happy traders but we are far from a secular bottom. You’ll know we’ve hit that when stocks and the whole equity culture of the US and the world changes. When people start outright hating stocks or even the thought of investing.

When everyone laughs at you or feels sorry for you for even hinting that it may be time get back in the stock market. When the valuation pendulum swings way to the other side and measures, whether based on price earnings or price dividend are so outlandishly extreme that you do a double take. That’s when you’ll know we’ve hit a secular bottom. One for generations.