Trader’s Narrative

Here’s this week’s sentiment overview:

Sentiment Surveys
Let’s start with the most common sentiment measures:

The AAII came in this week at 27% bullish and 46% bearish - little changed from last week (one percentage point variation, if you are that curious).

ChartCrafts’ Investor’s Intelligence results this week shows a bit more movement with the bulls and bears returning to approximate parity: bulls at 38.7% and bears at 36.7%

ISEE Sentiment
Amazingly enough, during this catastrophic bear market, the retail option trader, as measured by the ISEE Sentiment index has been completely unfazed. The index is a ratio of call to put option purchases (to open a position) and therefore, a low number denotes fear. Looking at the equities only chart of the ISEE from 2008 to now there is remarkably little concern as the index has only fallen below parity a handful of times:

CBOE Put Call Ratio
The traditional option sentiment index is mirroring what the ISE sentiment index is telling us. As you can see from the charts below, the last time puts were more popular than calls, we had a significant rally, which put in the low (for now). However, as the market continued to recover into the new year, it was puzzling to see fear also increase. And now as the market has weakened and approached the November 2008 levels, option traders are not concerned in the least:

Again, this is similar to last week’s sentiment overview where we saw evidence of too much optimism. All in all this tends to paint a fairly clear picture of the prevalent sentiment out there but not one that many longs will be happy to see.

UPDATE:
Economist Magazine Cover
Don’t know how I missed this since I was actually reading the magazine! Here is this week’s cover:

Here is the sentiment overview for the first week of 2009:

ISE Sentiment
On Monday I mentioned that the option traders on the ISE were shockingly optimistic, going long more than twice the number of calls than puts. Things quickly calmed down and the ISE sentiment ratio fell closer to parity at 123.

On the plus side, this resolved the “quietness” that had fallen over this options market. The range contraction of the ISE is no more. But to be honest, I was imagining it being broken to the other side.

The short term moving average (10 day) of the ISE sentiment ratio continues to be too high - reflecting a worryingly lopsided demand for call options by retail option traders.

CBOE Put Call Ratio
The traditional ratio measuring option activity spiked to 1.07 on January 7th and then fell again. I’m not sure if we can attribute too much meaning to this. Especially when the over all picture of the CBOE put call ratio is still one of optimism.

AAII Sentiment
The American Association of Individual Investors released their sentiment data for this week: bulls jumped sharply to 48.70% (from only 24% last week) and bears were only 35.06% of respondents (compared to 54.67% from last week).

Clearly we are seeing the average American retail investor jump on the bandwagon of hope.

Investor’s Intelligence
According to Chart Craft, this week’s Investor’s Intelligence sentiment survey shows 41.8% bulls and 34.1% bears.

We’ve watched a continuous increase in bullish sentiment from this indicator for the past few weeks. Specifically, this is a slight increase since the last week of 2008 when both bears and bulls were both equal at 38.5%.

As well, the last time we had more bulls than bears was back in August 2008 when the S&P 500 was trading at 1300. It was a momentary blip of exuberance but we all know what happened after.

You can see this on the chart to the left.

Hulbert Newsletter Sentiment
The Hulbert Stock Newsletter Sentiment Index (HSNSI) measures the optimism or pessimism of market timing newsletters. The “Santa Claus” rally added to the gains of the S&P 500 since November’s low, taking us 20% higher and technically into a new bull market.

According to Mark Hulbert, the HSNSI was at -18.9% when the S&P 500 hit its November 2008 low. This means that the average market timing newsletter was advising their clients to be short the market with that portion of their portfolio. But as of this week, they are now suggesting a +43.5% allocation (long).

Although we need people to get bullish (eventually), this is just way too much too fast. The ideal situation from a contrarian viewpoint is to see reluctance or disbelief after a rally. That’s not what we are seeing (from this metric at least).

On Wednesday - February 13th - after 3 consecutive up days, I mentioned the peculiar way that option traders were in denial of the rally and of the likelihood of seeing a pause:

It would be very normal for the market to pause and digest this short term move up but the negative sentiment is undeniable.

We got the “pause and digest” the following day on Thursday and today. So to dive into all that negative sentiment, here is the stock market sentiment recap for this past week:

LowRisk.com
I mention this sentiment survey sparingly because it is very jittery and much less famous than its peers. But this week’s reading of 64% bears and 24% bulls reminds me of the last time that bearish sentiment was 60% (June 2007).

Unlike then, this week’s bullish ratio (bulls divided by the sum of bulls and bears) is quite high at 27.27%. But there is no denying that the respondents are very gloomy about the Dow’s prospects. Their median guess of the Dow (closing value February 22nd) was 11852 - well below the Dow’s January swing low of 11,970.

Investor’s Intelligence
If you’ve been keeping up to date with these sentiment overviews then you know that the II survey has been insistently and stubbornly stuck with a clear bullish consensus. For contrarians, that has been disconcerting not only because II is a major sentiment survey but because it contradicted all the other surveys.

This week it seems “reason” has finally prevailed in newsletter land. According to ChartCraft, the keeper of this indicator, the bears now account for 35.6%, and the bulls 36.7%. While that may seemingly put them neck and neck, the historical data for this survey gives us a decidedly more bullish interpretation.

Newsletter editors are naturally bullish by nature, after all, optimism sells. So it is almost impossible to find less than a third of them bullish at any point in time, no matter what the market condition. The current percentage of bulls is as low as it was in the summer of 2006 and 2002 (and no other time since). So I can comfortably say that the II is officially flashing a contrarian buy signal - finally!!.

AAII
Meanwhile, the AAII (retail investors) sentiment has finally decided to come up for air from the depths of despair it had sunk to in January 2008. The AAII sentiment survey spent 5 consecutive weeks (December 21st, 2007 to January 18th, 2008) being 50% or more bearish. The bears are now “only” 42% (with the bulls at 33%).

We’ll have to wait a few more months to see if the stock market follows the previous script or if we stray. According to the above chart, we could find the S&P 500 at 1558 by June 2008.

That’s not a prediction, by the way. I’m just extrapolating from the historic averages. But it could turn out to be prescient, so write it down somewhere or bookmark this so you can come back and mock me

Consumer Sentiment
The most recent Reuters/University of Michigan’s consumer sentiment survey was released today and it shows a stumble from 78.4 to 69.6 - the lowest since 1992!

As I’ve discussed before, consumer sentiment measures are a contrarian indicator. By the time they reflect doom and gloom, it is too late to sell, and in fact a better time to buy.

Whether that is because of the time lag built into this kind of survey or whether it is because of the forward discounting ability of the stock market (or both), the historical evidence shows that significant lows in consumer sentiment are buy signals for stocks.

I’ll going to write more about this indicator soon.

Maybe it was too much bubbly and partying over the holidays that got the retail options traders just a tad too giddy for their own good.

It’s not surprising to see the market falter heading into the new year when the ISE Sentiment Index reached the altitude of 168 on the last trading day of the year (Dec 28, 2007).

This number isn’t extremely high and certainly not as high as the ISE has gotten in its history. But relative to recent readings, it is just high enough to make me uncomfortable.

We have a lot of other indicators lined up for the bull thesis so it is troubling to find this sticking out like a sore thumb. Of course, we never get a full confluence of indicators but the ISE is a very powerful and reliable one.

And since last time it helped me flagged a top in July: Turbulence Ahead For The Market, and the bottom in mid August: Market Due For Recovery, I can’t very well ignore it.

The weight of the indicators is still bullish, especially in the intermediate to long term, but right here, for now, I don’t think it is wise to be too aggressive in the short term. Unless the retail options trader pulls back their optimism we could be in for a rough patch.