Trader’s Narrative

Here is this week’s stock market sentiment overview:

Sentiment Surveys
In last week’s sentiment overview, ChartCraft’s Investor’s Intelligence sentiment survey came in at a 14 year low (for bullishness). This week there were only 22.4% bulls with bearishness remaining unchanged. This week’s numbers take the II to a 20 year record! From a contrarian point of view, the message is clear.

The AAII sentiment survey is whistling a different tune however. The bears fell dramatically from 61% to 40% and the bulls rose to 41%. That’s a dramatic shift. Not only for the decrease in bears but because technically we now have slightly more optimists than pessimists. For confirmation of a market bottom and a healthy rally, I’d prefer to see continued doom and gloom.

There was a similar uplift in mood for the Consensus sentiment survey. Bullish sentiment rose from last week’s 21% to 36%. Again, not the sort of thing that gives contrarians confidence for a sustainable rally.

Volatility
Now this is just insane. The VIX closed the week at 70.33 - that is a record, in case you’re keeping track. But a new all time high record isn’t what makes my eyebrows levitate. It is that the VIX ended higher than on October 10th 2008 - when the market closed lower than on Friday. So while the market is now higher, fear - as measured by the VIX - is actually more pronounced. Interesting.

TED Spread & LIBOR
The credit markets are continuing to thaw with both LIBOR and the TED spread falling. But, and that is a big but, we are no where near normalcy. Both indicators are at extremely elevated levels. They difference is that they are now going in the “right” direction (if you are a bull). But they still have a long ways to go to totally unwind.

Sell Side Indicator
The Sell-Side indicator measures the equity allocation recommendation of the average Wall St. strategist to their clients. As you can imagine, as a group they are a great contrarian indicator just like the newsletter editors (Investor’s Intelligence) or the retail investors (AAII). Here’s a good article which explains it in more detail.

Right now the average allocation is 58% - which is the lowest level in 10 years. However, if you look back more than that, it is clear that we are near levels which would only suggest a cyclical bottom for the stock market, not a secular one (at best):

University of Michigan Sentiment Survey
If we needed another sign that the US consumer is totally pessimistic, the recent Michigan sentiment survey shows an even lower reading than the last time I mentioned it in May (Conditions of a New Bull Market: Consumer Sentiment). At 57.5%, it is now lower than anything we’ve seen in almost 30 years. This is saying a lot when you consider all the shocks that the financial markets have been buffeted with over that time:

The lowest reading in the history of the survey was in May 1980, 51.7%. This most recent result is preliminary and may be changed when it is finalized on October 31st 2008. We actually saw a lower reading than this most recent number in June 2008 with 56.4%. Then things seemed to improve to 70.3% only to fall down again. In any case, these small details matter less than the overall picture showing a shell-shocked consumer.

As you’d imagine, in the upside down world of contrarian sentiment, extremely pessimistic consumer sentiment is bullish.

Hedge Fund Redemptions
Forget mutual fund redemptions, hedge funds, the sophisticated investment vehicles of wealthy individuals and institutions is hemorrhaging assets to the tune of $210 billion. It seems most aren’t absolute return vehicles but closed index funds because in the recent quarter, they produced terrible results for their clients. According to hedge fund watchers, this looks to be the worst year both in terms of asset flows and returns.

Of course, not all hedge funds suffered. Andrew Lahde posted +860& returns and closed shop after just one year.

It never ceases to amaze me just how horribly wrong regular people are as a group when it comes to timing the market. There is a whole cottage industry around trying to gauge their sentiment so it can be faded.

Being a contrarian isn’t as easy as simply doing the opposite of what the non-professional investors are doing though. The key is to pick your moment. You want to do the opposite of what they are doing only at extreme inflection points.

Escape to Cash
Take for example the current state of Canadian investors. In spite of seeing the market recover, they are so traumatized that cash holdings in Canadian households has climbed 15%. According to the investment banking arm of CIBC, this is the fastest pace since… c’mon now, this shouldn’t be difficult… 2002.

So Canadians are basically rocking back and forth in the fetal position. Just as they were at the bottom of a brutal bear market which cut the Nasdaq in half and decimated investment accounts everywhere.

They have cashed out $35 B of equity mutual funds in the past 6 months. And on a rolling 3 month basis, net sales of mutual funds is in negative territory (in other words, net redemptions). That is the worst state of the mutual fund industry since they have been keeping records.

Double Whammy
So on the one hand we have investors who don’t see the market correction coming, get excited and buy mutual funds. And when the market does correct, and they lose money, they are so shell shocked that they just sit there on a pile of cash while the market moves on.

The 1987 stock market crash lasted two months and panicked investors towards the safety of cash. The problem was that, according to the CIBC report, they stayed there for 16 months afterwards, missing out on an amazing run as the market recovered.

This is the sort of thing that drives regular people absolutely bonkers! The give up saying that the market is “rigged”. Truth is that money flows inevitably from weak hands to strong hands.

The good news in all of this is that with a bit of effort you can learn to zag when everyone else is zigging. This is not as simple as it sounds though. There is something innate within us that draws us to the safety of the crowd. So standing apart is excruciatingly difficult from a mental and emotional basis.

Caution, Caution, Caution
While this level of fear usually marks major market bottoms, it doesn’t mean that the stock market will go up without pause or retracement. In fact, from the percentage of TSX stocks trading above their 50 day moving average, it looks like this is just the right time to lighten up:

The fact that the market is now probably topping here does not negate the contrarian significance of the regular Canadian investor hording cash. Note that the market topped out in July 2007 and again in October 2007 without whipping the masses into a frenzy of stock buying. That is, they weren’t mortgaging their homes to buy stocks like the bubble years gone by.

And when the market bottomed in the summer of 2006 and 2007 it wasn’t enough to cause people to become shell shocked. For some reason it took the market correction in early 2008 for that. I have no idea why. Maybe it was the confluence of the housing market, the price of oil marching higher, the credit crunch, etc. All I know is that right now we have market sentiment so bearish it only appeared last in 2002.

On a related note, if you are interested in mutual fund cash levels and their significance for the stock market, check out Jason Goepfert’s award winning paper: “Mutual Fund Cash Reserves” located in the Charles H. Dow Awards folder of my free trading resource area.