Trader’s Narrative

Here is a concise summary of this week’s sentiment data:

Sentiment Surveys
For weeks now I’ve been pointing out that the really interesting scenario would be if we saw the market rally while bullish sentiment decreased (or inversely bearish sentiment increased). That is what contrarians look for because it signals that people are not really believers in the rally. This is a tricky concept because while a prolonged bull market requires wholesale participation by buyers, it is frustratingly difficult to recover from a bear market if everyone thinks that every single blip is the start of a full blown recovery.

ChartCraft’s Investors Intelligence weekly survey of newsletter editors showed a decrease in optimism for the first time since the start of this rally. The bullish side fell 4.1% points to 39.1% while the bears came in at 34.5% - almost unchanged from last week.

The AAII weekly survey of retail investor sentiment shows a similar picture. There was a 3% point increase in the pessimist camp with the bears at 39%. Meanwhile the bullish camp fell significantly - 12% points - from last week to 32%.

Option Sentiment
While it spent the whole week lower, the ISE Sentiment index jumped to 171 (equities only). This means that the retail trader bought 171 calls to open compared to 100 puts. While it is just one day’s data, it definitely shows that optimism is easily stoked.

In contrast, the short term moving average of the CBOE (equity only) put call ratio is still quite low, corresponding to market tops. If we adjust for the upward sloping range of the data we find it at a similar level to October 2007:

Insider Activity
The similarities to October 2007 just keep coming. From the Nasdaq Bullish Percent Index, to the above mentioned put call ratio. Now insiders are getting in on the act. According to Washington Services, that tracks such activity, corporate insiders are taking advantage of this rally to cash in. For the 3 weeks so far in April, insiders have sold $8.32 for every $1 they have bought of their company’s shares. The last time they were in a similar dash to sell was (you guessed it) October 2007.

What is even more alarming is that we are seeing the lowest amount of outright buying from insiders for the past 17 years. Since insiders are considered the “smart” players in the market, they obviously wouldn’t act this way if they believed that the worst was behind us.

Magazine Cover
The Economist’s cover for this week asks: “A Glimmer of Hope?”. While acknowledging the mood of acquiescence to the ‘recovery’, it outlines the disadvantage in believing that everything is fine now: The world economy and the perils of optimism:

“Welcome to an era of diminished expectations and continuing dangers; a world where policymakers must steer between the imminent threat of deflation while countering investors’ (reasonable) fears that swelling public debts and massive monetary easing could eventually lead to high inflation; an uncharted world where government borrowing reaches a scale not seen since the second world war, when capital controls ensured that savings stayed at home.”

Here is the summary of sentiment data for this past week:

Earnings Season
We are about to enter the heaviest weeks of earnings season, with some nasty surprises, so buckle up!

Sentiment Surveys
The weekly AAII sentiment survey reflects 36% as bears (a decline of -8% points from last week) and 44% bulls (a rise of 8% points). Not surprisingly, the rally is continuing to send positive ripples through retail traders.

ChartCraft’s Investors Intelligence survey of stock newsletter editors this week shows the most bullish posture since the start of this bear market (that is, assuming we’re still in it). With this week’s results, the optimists outnumber the pessimists for the the first time since January 2nd, 2009. Previous to that, it was in mid August 2008 and before that, a period of time from mid April to June 2008. All of those times coincide with market tops.

According to the Hulbert Stock Newsletter Sentiment Index (HSNSI), which measures sentiment among short-term market timing newsletter editors, while the market has spent the past 2 weeks treading water, newsletter editors are much more bullish. Two weeks ago they were suggesting to their readers an average long position of only 8.8% but now, that’s jumped almost 18% points to 26.5%. It isn’t the nominal value of the sentiment but the fact that there has been a remarkable increase in bullishness with no real market movement to provide a rational cause for it.

NFIB
It wasn’t that long ago when the National Federation of Independent Business (NFIB) Small Business Optimism Index fell to a new low. In April it once again set a record, falling to 81. Small businesses across America are continuing to retrench - no green shoots in sight!

Option Sentiment
Earlier in the week I outlined how the option traders are pushing their luck. Follow that link to get more details. During the rest of the week they continued to press their luck. The ISE sentiment index, tracking the retail options trader spent 3 consecutive days above 200 - meaning that they bought twice as many calls to open a trade as puts this week. The last time that we saw this many consecutive days of bullishness was in late December 2007 when the S&P 500 was trading at ~1475. The last time before that when the ISE sentiment index hovered over the 200 level for 3 or more consecutive days was in late October 2007 - when the market had just begun this brutal bear market. With odds like that, the rally is on very weak legs.

In confirmation, the CBOE put call ratio continues to hover around the mid-point (equity only data). This ratio ended the week at 0.56 - meaning that the option traders were buying almost twice as many calls to puts.

Fund Flows
Similar to the twitchy Rydex market timers, who are all of a sudden very bullish now, the typical US equity mutual fund buyer has finally returned to the market. Early fund flow data for the short term, weekly data, indicates that we are seeing tentative but clearly net positive inflows into US equity mutual funds. Of course, we can’t play a contrarian at all times. The stock market needs this capital injection - especially considering the gargantuan amount of scared money sitting on the sideline. But in the past, whenever these market participants have peeked out from under their covers and dared to re-enter the market, they’ve had their head handed to them. The most recent example was the new year top (January 2009).

NAAIM Survey
Although it slipped mention, the National Association of Active Investment Managers (NAAIM) sentiment survey was an emaciated 2.15 on March 4th, 2009, just days before the launch of this latest rally. Although I didn’t mention it at the time, I’m not sure if it is meaningful because in the short history of this sentiment indicator, there are two weeks with a more bearish outlook: July 9th, 2008 (2.03) and October 8th, 2008 (-2.97) and neither of them really resulted in much of a rally. In July, the S&P 500 went sideways and eventually wilted and in October the market thrashed about but quickly melted even lower. While I continue to monitor lesser known indicators like the AAIM, I’m not totally convinced that it has proven itself to deserve our full attention.

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I’ve been sounding off a cautionary note as action in the equities market appears top heavy. But today it became obvious that the option traders are starting to really push their luck:

Although it is just one data point, having so much call buying that it pushes the ratio to double the number of calls to puts is rare. The last time the CBOE put call ratio was trading at 0.50 or lower was in December 2007 when the S&P 500 was at ~1500. You can see a more long term chart of the put call ratio in the above link.

And it isn’t just the option traders on the CBOE. The equity only ISEE sentiment index - which specifically measures retail option traders - came in at 203 today. That means 203 calls were bought to open a trade compared to 100 puts bought to open a trade. The last time this ratio was above 200 was December 30th, 2008 - just before the market took one too many sips of the bubbly and had the New Year’s tumble.

I’m a bit hesitant because there have been some data integrity issues with the ISE before. So to make 100% sure, I’ve contacted them to confirm the most recent number. If there is a change, I’ll write about it. Otherwise, the number stands.

If you’re new to this new method of looking at retail option traders, then this is a good introduction to the ISEE sentiment index.

I’ve been yammering on about market bottoms, bullish indicators and contrarian sentiment and other similar ideas for some time. The only thing I haven’t done is reach through the monitor and slap you around till you get some long exposure

Today money flowed into advancing stocks to a staggering degree. As measured by volume, advancing issues were 3.5 times the declining ones on the NYSE and 8.3 times on the Nasdaq. That’s short of the sort of stampede that gives us the rare and valuable 90-90 days but there was no question buyers were in control.

Yesterday’s market action was similar although much more muted. Coupled with Monday’s hammer candlestick, we now have 3 consecutive up days. It would seem (if I may count my chickens before they hatch) that we are having a successful retest of the mid January lows above the 1320 S&P 500 level.

You’d think that in a such a scenario people would be bullish, or atleast a bit excited, right?

Turns out that while the market has been going higher, people are actually not excited at all. In fact, they’re slightly more bearish! Check out this chart comparing the S&P 500 index (candlestick) with the CBOE equity only put call ratio (line):

Take yesterday as an example. While the S&P 500 reached 1360 and managed to close up 0.93%, the CBOE equity only put call ratio went from 0.68 to 0.78 - meaning that people bought more puts than the previous day. Also, the ISEE Index dropped from 115 to 82 - meaning that people bought less calls than the previous day.

Today the market went up another ~1% and we had the CBOE put call ratio drop ever so slightly (almost unchanged) and the ISEE Index dropped again, from 82 to 72. That’s equally as pessimistic as February 5th, when the market fell 3.2% in one day!

Of course, the usual and expected pattern is for option traders to buy calls when the market goes up and to escape into the shelter of puts when it goes down. The opposite happens from time to time and I don’t want to read too much into just two day’s worth of data but nevertheless, it is noteworthy.

It would be very normal for the market to pause and digest this short term move up but the negative sentiment is undeniable. And it is congruent with other things I’m seeing. For example, most of the email I get is about how we are about to fall again and how the “bulls are going to get slaughtered”, etc.

The market can be a sadistic vixen, exerting maximum pain on the maximum number of people. That’s when it pays to be in the minority.

Today, the CBOE equity only put call ratio hit 1.22. Which means that for every call there were 1.22 puts.

To find a more extreme reading in this indicator, we’d have to go back to the late summer of 2004 where the S&P 500 found footing at 1065.

On August 6th 2004, the equity only put call ratio hit 1.28 (see graph below):

Interesting to note that the S&P 500 today closed very weak, but at around 1460. Just around the top of the previous swing high in mid February 2007. If this area acts as it should, the market will find support here next week.

UPDATE: The data I used for this post was later found to be incorrect. Let that be a lesson (it certainly was for me) to double check your data.