Trader’s Narrative

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.

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.