Trader’s Narrative

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.

This week sentiment recovered from the abyss into which it had fallen. This isn’t surprising considering the strong lift-off the market had last week. But even so, it doesn’t yet give us any reason to doubt the veracity nor the potential of the rally to continue.

Hulbert Newsletter Sentiment Index
According to Mark Hulbert, the Hulbert Stock Newsletter Sentiment Index (HSNSI) was -22.5% on Monday, March 24th, 2008.

On March 10th, 2008 when we had the lowest close in recent history, the HSNSI was a little bit lower at -25.9%. Which means that although the market has recovered from such lows, the average market timing newsletter writer is still very much bearish and recommending to their subscribers that they in fact short the market in their portfolios!

This is even more significant when we compare the reaction this rally has provoked to the previous rally in mid January. Right after the market recovered from those intra-day lows and went higher, newsletters quickly jumped on the bandwagon and the HSNSI increased right along with the rally more than 22% points.

This is exactly what I was referring to when I answered Jim’s question about trend and why I’m not bearish in the current market condition.

Sentiment Surveys
The AAII retail investor’s sentiment survey continued to recover with an increase in optimism: 42% were bullish and 34% bearish. This puts them square in neutral territory.

The II (ChartCraft’s newsletter sentiment measure) similarly recovered with a small decrease in the number of bears (41%) and a small increase in the bulls (36.7%). But unlike the AAII, the newsletter editors are still very much at extreme levels of bearishness which have historically coincided with market bottoms.

Although sentiment has shifted from the lopsided scenario we had, I don’t think this means that the rally it birthed is in danger. For the market to go up we need people to start buying again and for that, they need to not be so afraid. That, however, is different than a quick shift from one extreme side of sentiment to the other.

ISE Sentiment
This week we’ve seen a consolidation after last week’s rapid recovery. The ISE Sentiment Index, however, is showing that this has lead the retail option traders to quickly lose any excitement for the rally:

ROBO Put Call Ratio
This proprietary measure created by Jason Goepfert of SentimenTrader.com keeps track of what the small retail option traders are doing.

The most recent data is showing that the retail investor is very worried. The ROBO put call ratio is 0.91 - that’s from 0.68 in mid February 2008.

To find similarly pessimistic times when the retail investor was buying puts so frantically, we’d have to go back to early 2003, just as the bear market was coming to a close.

Because of the delay in getting OCC data, this reflects what was happening in the option market last week. But it is nonetheless useful on an intermediate to long term time horizon.

Is it just me or is this tape incredibly frustrating? We’re dripping lower, seemingly on our way to test the January lows. But it is anyone’s guess if we we’ll get a head fake lower and then reverse up or just cascade down into a continuous bear market decline, ala the 1970’s.

To help light the way, here is the sentiment overview for the past week:

Hulbert Newsletter Sentiment
According to Mark Hulbert, the keeper of the HSNSI (Hulbert Stock Newsletter Sentiment Index), there is contrarian arguments that the January low will be intact.

This week’s market decline brought down the portfolio allocation of stock newsletters to -16.4%. That means the average market timing newsletter iss advising their clients to be short the market.

The HSNSI is now not only below the January 22nd lows, it is the lowest such sentiment reading since October 2005 when it scraped -30%. The silver lining in the clouds is that newsletters are dejected and starting to throw in the towel. They are not stubborn in their denial of a declining market. That, according to contrarian analysis, sets the stage for a potential rally.

Option Market
As I pointed out yesterday, the CBOE’s equity only put call ratio spiked to a four year high. Today it retreated to 0.90 - still quite high but backing away from everest proportions.

On Friday it was the ISEE Sentiment Index’s day to turn heads. I suppose the retail traders read the headlines and watched the TV reports from Thursday’s trading, got freaked out of their minds and started buying puts hand over fist, pulling the ISE sentiment index fdown to 65 - the lowest it has been since January 17th of this year.

On that day the ISE index was 60, meaning that retail traders were only buying 60 calls for each 100 puts. Strangely enough, the market bottomed a few days later (January 22nd or 23rd, depending on whether you go by the intra-day low or the close) when the ISE ratio was much higher: 105 and 98!

This is exactly what happened during the March 2007 retest of the bottom. During the first decline, the ISE sentiment dipped to the 60’s but during the subsequent retest, it was at par (100).

AAII Sentiment Survey
Finally, among the sentiment surveys this week, the AAII results stand out with a meager 22% bullish and 50% bearish (again). During the January decline, the AAII survey showed similarly low bullishness but the rally it ignited was mild to say the least. You remember this chart, right?

We’ll have to wait a few more weeks to see if it will be borne out but it is an understatement that so far, it has been a disappointment. By the end of this month, we’ll have given it the 13 weeks it requires. Let’s see if the AAII contrarian sentiment analysis lives up to its history - mark your calendars!

Investor’s Intelligence
In agreement with the retail investors, this week’s Investor’s Intelligence sentiment survey shows the newsletters at 42% bullish and 37% bearish. Both those levels correspond to extremes, which can be interpreted according to contrarian thinking as very bullish for the market.

To wrap up, while we may have to endure some further turbulence due to our proximity to the January lows, the sentiment is horrible out there and it will set the stage for an intermediate to long term rally. The trick will be to not get shaken out of long positions while still maintaining discipline.

Everyone was watching the line in the sand: 1310 on the S&P 500 and it was crossed today.

The market just can’t get any sort of rally going, even when it is recovering from an extremely oversold condition. That’s not good.

Now we’re rolling over and the only thing that gives the tape a jolt are rumors of Ambac’s salvation. But I try not to get bogged down in this sort of guessing game. I’d rather look at the indicators that have worked in the past.

Out of Breadth
I pointed out a few intriguing charts in last week’s sentiment overview. We haven’t gotten the breadth reading I was expecting: the percentage of S&P 500 stocks above their 10 day moving average bounced up from 13% instead of going below 10%.

The number of declining stocks shot up to 2800, well above last week’s numbers and those of the January low. Like everyone else, I don’t know what will happen but according to the charts, such a spike in the number of declining stocks has in the past put a floor under the market within a few trading days.

Option Traders Panic
The most obvious number to jump out at me today was the ratio of puts to calls for equities (from the CBOE). We’ve had recent instances of this important ratio (almost) piercing par but thanks to today’s abysmal market we’d have to go back farther than four years to find a more frightened option market.

For those keeping track, the number was 1.1183. Paradoxically, of course, this is good. When the market is tanking, you want people to be scared. If they’re nonchalant, a cascade lower usually follows because everyone who wanted to sell hasn’t been frightened enough to sell. Fear exhausts the weak hands and forces them to take action.

After today’s, the next highest CBOE equity only put/call ratio is from Friday, August 6th, 2004: 1.28 - a major low in the market. Pull out your long term charts and take a look.

Notice how in 2004 the put call ratio kept spiking higher and higher?

I’m pointing that out so that you don’t think it has to be contained by an arbitrary numerical barrier. What we are seeing is definitely a panic but that doesn’t mean it can’t intensify.

Most significant market bottoms are not “V” shaped. That is, the market doesn’t just spike down and then suddenly reverse up. Often times it recovers, only to retest the low. A retest, however, can be slightly above or below the previous swing low. So while we once again seem to be approaching the January 22nd and 23rd levels, I’m going to be watching my technical indicators to see how the market will react to it.