Trader’s Narrative

Here is the sentiment wrap-up for a week that saw new yearly highs:

Dow 10,000
Yes, the Dow Jones reached and surpassed the magically round number 10,000. But in case you were too busy to count, this is for the 26th time it has done so in the past 10 years. So that means we’ve had about 10 years of zero returns (excluding dividends and inflation). Those specialty party hats the NYSE hands out are well worn by now and no one really knows what we’re supposed to be celebrating.

Sentiment Surveys
Turning out attention to the AAII weekly sentiment survey, we find a large jump in optimism among retail US investors. This week 47% are bullish - a jump of 12% points from last week. In contrast there are 34% bears (a drop of 7% points). Usually this survey gets my attention anytime a particular camp has majority. We’re not there yet, but this is mighty close.

While you will most likely interpret this lopsided survey result to be contrarian bearish, keep in mind that the previous time we saw the bullish ratio this high was a few months ago in July 2009. As the chart shows, the S&P 500 index shrugged off any suggestions of ‘too much optimism’ and barreled ahead gaining 150 points. If I were relying on just the AAII survey, ideally I’d like to wait for the bulls to get to 50% or more before being confident about it tripping up the market.

Investors Intelligence
While the AAII bulls took the reins this week, the weekly survey from ChartCraft measuring the stock newsletter editors sentiment has been dominated by the bulls for a few months now. This week was no exception as the Investors Intelligence indicator came in with 47.2% bulls and only 26.4% bears. So this isn’t all that helpful because while II has been stuck showing about twice as many bulls as bears, the market has continued to rise.

National Federation of Independent Business
The monthly NFIB survey results show September inched ahead at 88.8 - which is pretty unimpressive since it isn’t even higher than the results in May (88.9). As well, 6 of the 10 sub-components were either down or flat suggesting that the tiny improvement came from a narrow contribution.

The details of the NFIB survey show the huge disconnect between Wall St. which has enjoyed a 60% rally and an attitude of ‘back to business as usual’ (with bigger than ever bonuses) and Main St. which is still struggling with a very weak economy. Small US businesses are not ready to build up inventories, nor are they planning on expanding capex spending, nor are they hiring, nor are they expecting credit conditions to ease. Small business in America is referred to as the engine of the economy but it has been neglected while ‘too big to fail’ banks and investment houses become even bigger and received billions of dollars from the government.

Option Traders
The sentiment in the option pits continues to be very very bullish. While some of the penchant for calls can be attributed to the stock replacement strategy, I don’t think that explains enough to discount the alarming extent of the skew.

The ISE sentiment index (equity only) which exclusively measures retail option traders opening transactions spent 4 days out of the 5 trading days in this past week above 200. That was enough to take the 10 day moving average of the equity only call put ratio to 200.8 which is the highest since November 2007. For a chart, see the sentiment overview at the start of the month.

The CBOE (equity only) put call ratio is also showing a similar pattern of excessive call buying. Its 10 day simple moving average is 0.52 which is among the lowest levels for many years. In the following chart, you can see how the S&P 500 has responded when we’ve seen this much optimism:

This is by no means an exhaustive or quantitative study but it does show that while the equity markets can rise a bit in the face of such bullish option sentiment, sooner or later, it catches up with it. Either the market goes sideways or corrects sharply. Hmm… that sounds familiar.

Volatility
As an alert reader pointed out, the CBOE volatility index (VIX) is now scraping a bottom not seen since September 2008. In case you’ve blocked out that painful memory, that was just before the catastrophic waterfall decline which took the S&P 500 index down to a 6 handle. But from all the historical studies that I’ve seen, a low VIX doesn’t really mean anything, not in the way that a spike high denotes a panic bottom for equities. After going through some absolutely insane volatility we are once again returning to historically normal ranges so I don’t think there’s much edge here.

IPO Pipeline
The private equity groups are getting more and more of their holdings gussied up for public offerings. If you know how shrewd an investor these institutions are, you do not want to be on the other side of their average trade. After all, timing the market is pretty much all they do. They fund or take unloved companies private and then when the public sentiment is ripe, they sell them back again for a higher price.

In the following weeks, Fortress, KKR, Blackstone and Bain Capital will be bringing a half a dozen IPOs online. Unlike the traditional IPO where a company raises money for expansion, these are exits where the firms that took an opportunistic stake want to get their money back with a healthy return. Usually a healthy IPO market is a sign of a healthy equity market and only when it become excessive should we take a contrarian stance. But now, I’m watching the number of IPOs and the welcome they receive in the market as a gauge of the mood out there.

Here’s this past week’s overview of sentiment data:

Sentiment Surveys

The retail investors and traders tracked by the AAII weekly sentiment survey continue to pull in their horns. The bears came in at 49% a 4% points increase from last week and the bulls were at 40%, a 6% increase from last week. Pulling back to provide some perspective, we’re still mired in no man’s land - neither optimistic nor pessimistic.

Similar to last week, the Investors Intelligence sentiment survey of newsletter editors was almost unchanged. There were 40.9% bulls, 28.4% bears and the rest neutral. The next test of sentiment is how it will react to a fall in stock prices. Will people throw in the towel? or persist in a new found optimism?

TED Spread
Although it was prominently featured everywhere just a few months ago, the TED spread has fallen off everyone’s radar now. After reaching a climax on October 10th, 2008 it has continuously fallen lower to reach levels that it was trading at in early August 2007:

It still has quite a ways to go to reach the multi-year lows of 15 but it is just another indicator returning to normal and signaling that the worst is over for the credit markets.

Volatility
The volatility index (CBOE’s VIX) continues to take one step forward, two steps back - slowly grinding lower. It gave up the 30 level again this week on its way lower. Mr. Market is remarkable, who would have every imagined that we would be seeing 30 as ‘low’? For a long term chart of the VIX and further details on what this means for the market, check out Volatility Continues To Melt Lower.

Options Sentiment
The ISEE (equity only) call put ratio was elevated for the whole week and for Friday it was 237 - meaning that for every 100 puts, retail option traders were purchasing 237 call options. To find an ISE sentiment index reading higher we have to go back more than 2 years to the last day of trading for the year on December 31st, 2007 when the ratio was 241 (and the S&P 500 closed at 1468.

Even so, I’d prefer to see more than a one day spike because the last time something similar happened, it turned out to be completely false. It was on March 9th when the ISE ratio doubled within a few days. But that was exactly when the market started this confounding rally. For that reason I’d prefer to see more than a few days of such extreme optimism.

The CBOE (equity only) put call ratio hasn’t confirmed the ISE optimism - which is another reason to not be jumpy. This week’s put call ratio was moderately higher but we didn’t see a significant change so the chart I showed in last week’s sentiment overview is still helpful.

After seeing a 25% rally, the reasons to be cautious continue to pile up:

ISEE Index
The ISE call put ratio, otherwise known as the ISEE index started the week off fairily high. The equity only sub-index came in at 169 on Monday and continued to stay elevated. On Tuesday it was 170 and today it closed at 167.

I’ve found the ISE sentiment tough to decipher during this bear market because of how strange it has acted but the 3 continuous days at 169 and higher show a level of call buying that we haven’t seen since very late last year (Christmas and beyond). That, as you’ll remember, was a very poor time to be bullish on the stock market.

CBOE Put Call Ratio
The more traditional put call ratio - also equities only - shows a similar picture. Here’s a 21 day moving average of the CBOE put-call ratio with the corresponding tops in the market:

Cramer Bullish
Remember Jim Cramer? The guy who was gutted like a fish by Jon Stewart? The guy who went on TV, almost weeping, telling people late last year to take their money out of the market for the next 5 years? Yeah, that guy, he’s bullish again and leading “Cramerica”, once again, to the slaughterhouse. Last Thursday he announced that the “depression” is over and the market has seen the bottom.

Earning Season
With the Alcoa (AA) kicking off earning season, we are now in a market cycle which lasts about a month and which is well known for its weakness. I’m not sure why exactly earning season is a bad time historically to be invested in the market but it is. Numerous studies have shown it to varying degrees. You can stay up to date with this earnings calendar from the Wall St. Journal.

Sentiment
Finally, as I’ve mentioned already in previous sentiment overviews, we’ve seen a general return to optimism through the various sentiment indicators and surveys. Although some of this is to be expected and warranted for a return to normalcy, it is another element we have to throw into the pot.

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Investors Intelligence
On Tuesday, just as the market was poised for its rocket ride higher, ChartCraft’s Investors Intelligence survey of stock newsletter editor’s sentiment showed 26.4% leaning bullish and 47.2% bearish. That’s a pretty good level of pessimism but not nearly as much as we saw late last year when bearish respondents came in at around 55%. It will be interesting to watch next week’s numbers to see if there is a continued collapse in hope or whether the market’s recent bounce causes people to jump on the bandwagon again (as they have repeatedly during this bear market).

AAII
After last week’s historic AAII sentiment survey results, it isn’t surprising to see some push back. The bearish camp shrunk by 15% points to 55%. That’s still very high but no contrarian likes to see such a the sudden move in response to the rally we saw. The optimists rose 9 percentage points higher from last week to 28%. The survey was taken on March 12th, after Tuesday’s massive one day rally. Real capitulation would have been either a more timid move towards optimism or continued slide into further pessimism.

Options Sentiment
The options market continues to behave very strangely. After the spike high in the ISE sentiment, that option ratio calmed down a bit but it is still showing an elevated level of call purchases (compared to puts).

The CBOE (equity only) put call ratio concurs with a very low reading for the whole week. The averages (10 and 50 simple day moving average) are both stuck in the middle, not providing any real signal.

OTC Volume
One measure of investor optimism is the activity in the “over the counter” market. Since it has less regulation and oversight, as well as smaller, riskier securities, it is a good barometer of investor sentiment. In the past, extremes of activity in the OTC market have marked the “blow off” stage. In a hurricane even turkeys can fly and in a bull market, the highest flyers are often the lowest quality OTC stocks. Right now the level of activity in the OTC market is extremely low. Lower than the 2002-2003 bear market low, lower than the 1998 crisis low. The lowest in at least a decade, in fact. If OTC activity had an EKG, it would have flat-lined. Which is good in a sense because it shows that we have wrung out every single drop of excessive speculative energy (at least in this corner of the market).

Insider Buying
Corporate insiders continue to pour money into their own companies stocks with renewed vigor. We are now approaching the level of buying frenzy that we last saw in late November 2008. Although these are generally viewed as the “smart money” crowd, over this bear market, they have not shown the usual agility in timing the bottom. If the market continues to rally, they will have finally been proven right.

Mutual Fund Cash
The cash buildup in mutual fund portfolios continues. The estimate now is that almost 6% of the average equity mutual fund portfolio is made up of cash or equivalents. We need to “normalize” that to take into account different monetary conditions over time (see previous mention for more info).

We are now approaching the equivalent of the mid-1990’s for normalized cash holdings. This isn’t the extreme that we saw, for example, in the mid 1970’s or the early 1990’s. Both of those times coincide with a massive buildup of cash and a lasting market bottom. However, today’s level is enough to stoke a bull market - assuming the other ingredients are also there.

This could be caused by the general pessimism pervading Wall Street right now. And it could also be that the average fund manager’s hand is forced by the unforgiving onslaught of mutual fund redemptions. The fund flow data certainly shows that the average retail mutual fund owner has had enough and is cashing in (possibly at the bottom or close to it).

Magazine Cover
This week’s magazine cover indicator comes courtesy of The Economist:

There’s a lot to cover in this week’s sentiment overview, so let’s get started:

Investors Intelligence
This week’s ChartCraft’s survey of stock newsletter writers delivered only 29.7% bulls - up slightly from last week. And almost unchanged from last week, 44% bears.

Market Vane
Market Vane dropped again to the low 30’s - a level last seen in October to November 2008 when the market made a short term spike down. That’s relatively low but not on an absolute level since it fell to sub-20 readings in the last bear market bottom between 2002-2003. To read more about Market Vane and its origins, check out A Brief History of Contrarian Analysis.

AAII
But the most fascinating and historic reading comes to us from the AAII weekly survey. The latest American Association of Individual Investors (AAII) data shows what can only be describe as total and utter capitulation. As of Wednesday (March 4th, 2009) 70% expected the market to continue to fall, while only 19% continue to see better times ahead.

The only data point from the AAII survey that approaches this level of gloom is back in October 19th, 1990 when a paltry 13% of respondents were bullish and 67% were bearish.

Source: SentimenTrader.com

ISE Sentiment
In contrast, the ISE put call ratio (also known as the ISE Sentiment index) continues to tread water, seemingly oblivious to any risk. The only data that can be interpreted as slightly bullish is that for the second time this year, it fell below parity - barely. On Wednesday March 4th, 2009 the ISE Sentiment fell to 95. The only other time it fell below 100 was back in February 3rd 2009 when it hit 97. Since January 1st 2008, it has only fallen below the parity level ten times.

CBOE Put Call Ratio
Similar to the ISE data, the CBOE put call ratio shows no sign of flight to safety. On March 5th it reached 0.90 - a relative high but by no means a level which shows a serious sense of risk.

Corporate Insiders
Once again corporate insiders stepped up to the plate to buy their companies’ shares. Although there is a noticeable spike in purchases (relative to sales), I wonder if it means anything because it is another in a series of similar spikes that we’ve seen going back to November, July and March 2008.

TED Spread
This indicator has fallen off everyone’s radar - and for good reason. Right now the TED spread is still high at around 1.0 but it is far from the peak of 5.0 reached at the zenith of last year’s credit crisis. Still, relative to its own long term average it is still very high since it averaged around 0.4 for the past few years.

Hulbert Sentiment Index
The bad news is that at the start of the week, the Hulbert Stock Newsletter Sentiment Index (HSNSI) is at -20%. Meaning that on average, the newsletters that time the market are advising clients to short the market with 20% of their portfolio. Although this is a low number, HSNSI was more than twice as low last July. So while the market has continued to fall, stock timing newsletters are half as pessimistic.

Compared this to the previous significant market bottom in March 2003. On March 10th, the HSNSI was -19.2%, almost equal to where it stands now. But back in July and October 2002, the HSNSI was -15% and +20% respectively. So clearly, we aren’t seeing full blown capitulation from market timing newsletters.

Magazine Cover
Business Week is one of my favorite magazine indicators because it has such a rich contrarian history. This week’s cover isn’t as pessimistic visually as the corresponding article.

Inside, the cover article goes over the failure of the usual indicators, whether sentiment, technical, monetary, etc. to be act as guides in this past bear market. It quotes experts ranging from James Stack of InvesTech, the Leuthold Group, and TrimTabs’ Biderman who each metaphorically throw up their hands in frustration. The gloomy outlook is punctured by a few positives but the conclusion is:

A more probable outcome is the one drawn from the narrow history of bear markets that grew out of financial crises. In it, the bear scenario continues to play out until the bull takes over, with more debt busts and government trial and error until things get set right again. That could mean two more years of bouncing around and then another six or so before the Dow is back above 14,000. Not long ago, such an outcome would have seemed unimaginably bleak. Given the other possibilities, it doesn’t seem so bad now.

Source: When will the the bull return?