Trader’s Narrative

We stared into the abyss and staring back at us was this week’s sentiment overview:

Investor’s Intelligence
I mentioned in last week’s sentiment overview the surprising bearishness of newsletter writers as measured by Chartcraft. This week they have outdone themselves with an eye popping 44.7% bearish level.

To find this sentiment equally or more pessimistic, we’d have to go all the way back… are you ready? to 1998.

Which, if you are old enough to remember (or agile enough to look up) was a time of unprecedented market turmoil brought on by a gaggle of PhD’s from Chicago running a little hedge fund called Long Term Capital Management. Back then, the II bears reached 50%.

Hulbert Newsletters Sentiment
According to Mark Hulbert, the stock market newsletters with the best long term track record are much more bullish compared to those with a track record worse than buy and hold. They in turn are suggesting being short this market. So which side do you want to be on? Of course, a track record doesn’t guarantee anything except experience. But considering the dearth of other measures which point to a bottoming process, it isn’t too hard to see this as another corroborating indicator.

Optionland
The CBOE equity only put call ratio has backed off its spike high - reached earlier this month. This is normal behavior for this indicator as the market now tries to pull itself up by the britches.

The ISE Sentiment index on the other hand, never really reached extreme levels during last week’s close call with the January bottom. To be honest, I had been watching it in case it did because that would have signaled that the retain option traders were giving up any hope of a bounce off those levels.

Magazine Cover
Here is the current Economist magazine cover:

Although it is decidedly negative, I don’t think it reflects anything more than what is really going on on Wall St. right now.

Subdued VIX
Although volatility, as defined by price movement in either direction, has been truly volatile, the VIX has refused to pierce 36 as it has in the past instances of market declines.

Part of me would like to see the VIX spike to crazy levels but I also have to remind myself that not all market bottoms are alike. As they say, the past rhymes, it doesn’t repeat.

So while it would be nice to have this yet another indicator among the myriad we already have, it isn’t really necessary. And perhaps there are structural reasons for this that will persist even after this current turmoil.

Repo Market Failures
There was such a mad dash for safety that the repo market seized up after record failures to deliver collateral - US government treasuries. Rates also scraped the bottom of the barrel at 0.38%! And I thought the rates a few days ago at 0.92% were low.

I mentioned that the Fed is still way behind the curve (even after the recent rate cut). This is illustrated by the gap between the 3 month Treasury Bill and the Fed Funds rate. As well, so far this year, the general collateral rate (rate for borrowing/lending US Treasuries) has been on averaged 63 basis points lower than the Fed’s overnight target rate. That is in comparison to only 8 basis points in past decade.

See my point now? There is no doubt that the Fed has exacerbated this situation by refusing to get ahead of the repo/bond market.

Today’s morning gap down freaked out a lot of longs (myself included). But if we could separate the last few hours into its own trading day, it would have been a knock out.

Contra Hour
The first hour belongs to the amateurs as their previous day’s orders are matched but the last hour of trading, referred to as “contra hour”, belongs to the pros as they take advantage of cheap prices to buy (or rich prices to sell at). Often, the beginning of the trading day and the end are mirror opposites of each other, like today.

Market Internals
Yesterday’s market was notable for giving us a number of new records but probably the most remarkable was more than 30% of all issues trading at a new low. This only happens once in a blue moon and as you can well imagine, a snapback follows.

Today’s market action was a mixed bag since prices struggled for most of the day. Even so, we had an almost 3:1 ratio of advancing to declining stocks on the NYSE. For the Nasdaq it was closer to 2:1. If we indulge in the fantasy that the last few hours were the whole trading day, then we may have even gotten a 90-90 up day. But that’s just imagination… back to reality.

Sentiment Holdout
As I’ve noted, the lone holdout in the sentiment landscape has been the Investor’s Intelligence measure of newsletter writers. Mark Hulbert confirms in this video, through his more quantitative indicator: the Hulbert Stock Newsletter Sentiment Index

But with all due respect to Hulbert, when we find the retail investors gripping the morning paper in a cold sweat as they frantically look up their portfolios, having first remembered to wear Depends undergarments… sentiment is skewed enough to create an inflection point. No matter what the newsletter writers may think.

Also, Hulbert doesn’t mention in the video that the 10 best risk adjusted market timing newsletters are for the most part still bullish. Interestingly enough, the 10 worst newsletters are actually recommending an average equity exposure of 13% short.

My continued bullishness may be seen by some as stubborn, but after looking at the sentiment out there, what other position can you take?

Option Traders Freak Out
The ISEE index recovered from a low of 60 - a low enough level to show severe panic in retail option traders. Although we don’t have long term data for this ratio, the data that we do have indicates that this is low enough to stoke a rally or at least halt a decline.

The more traditional CBOE (equity only) put call ratio once again came in near 1.0 today - this is the third time this week that it has been above or just at parity. In the past 4 years, we’ve only seen parity broken a handful of times. But to see a grouping of such high put call ratios is highly unusual.

I think it is safe to say that option traders, and especially the least experience and least capitalized of them (retail) are in full freak out mode:

Sentiment Surveys
The only traditional sentiment measure that is not showing excessive bearishness is Investor’s Intelligence with 45.6% bulls and 26.7% bears. A few people have asked me about the disparity between it and other sentiment indicators. Honestly I don’t know what is really going on but as I’ve said before, you have to understand that it is very different from other measures.

For one, newsletter writers are a generally more optimistic bunch (since bullishness sells better than its counterpart). Second, II is tabulated through the subjective thinking of one person, Michael Burke. He categorizes newsletters as either bulls, bears or neutral from not necessarily their portfolios but also what the writer is saying. Since the newsletters can’t themselves, in effect, “vote”, this measure is open to the personal bias of one person.

So maybe that explains the discrepancy or maybe it doesn’t. In the end, it is one measure among many. I’d rather take the general judgement of the group, than single out any one of them.

LowRisk’s recent 30 day outlook is decidedly gloomy with 56% bearish and 32% bullish. Market Vane’s bullish percent dropped to 48% and although that sounds too high already to be bullish, you have to consider that for the past 4 years, it has oscillated between 75% and 55%. Likewise, Consensus‘ bullishness is at 47%.

AAII is showing panic-level bearishness again with 54% bears and only 24% bulls. Check out last week’s chart to see the correlation between such high bearish AAII sentiment and stock market performance.

According to Jason Goepfert, waiting two weeks after a bearish percentage above 50% gives us a better chance of finding a winning trade: 24 from 29 instances with an average return of +3.1% (over two months). He also says that the “average drawdown (i.e. maximum loss) of -3.2% was dwarfed by the average maximum gain during the trades of +5.7%.”

Rydex Ursa/Nova Ratio
Before leveraged ETFs, the only way retail traders got long or short aggressively was through the Rydex Nova/Ursa funds. Although they have become somewhat of an anachronism, their ratio is still useful to show the retail investor’s mood.

Not surprisingly, we are seeing a dash into the bearish leveraged fund (Ursa) as the “dumb money” goes into panic over the recent market losses.