Trader’s Narrative

The fabled trillion dollar cash hoard that US mutual fund investors are sitting on is well known by now. But what isn’t equally well known is just what they are doing with all that cash. We do know that after reaching a peak right at the March lows, the shell shocked US retail investor stopped stuffing cash into their accounts.

At its peak the cash hoard was about $4 trillion dollars. By the start of this month, it was down to $3.56 trillion and the most current data shows that retail investors have continued to slowly exit their safe haven, taking the number further down to $3.48 trillion. So where have all those billions of dollars gone?

From the fund flows data it seems that the vast majority of it has been funneled to the fixed income market, and more specifically, taxable bond funds. I showed a pie chart of the fund flows in last week’s sentiment overview to juxtapose the extremely skewed ratio of money flowing into bond funds vs. equity funds.

But a pie chart doesn’t really do the data justice. To get a much clearer idea of what is going on in the hearts and minds of the average US retail investor, let’s take a look at how they’ve allocated their money between domestic equity funds and bond funds:

The data for the bond funds is for both taxable and municipal bond funds. As well, this month’s data point (shown in a darker shade) is partial because it including only the first 3 weeks. Nevertheless, this chart is a telling a remarkable story.

First, not surprisingly, as the bear market took hold, people started to react by taking their money off the table. The worst month was October 2008 (not March 2009) when $72 billion was withdrawn from equity funds - $47 billion of that from domestic funds. At this point of maximum panic, US investors sold everything, even bond funds. They only trusted one thing: cash.

But by the start of the year, while they still distrusted the stock market, they began to change their mind about bonds. Each month they put more and more money into bonds, even as the stock market launched on an astonishing rally.

Month after month, as the S&P 500 went on to higher highs, US investors continued to ignore equity mutual funds. Then most shockingly, during the first 3 weeks of this month, they actually withdrew funds from this asset class! At this rate, by the end of the month, we’ll see outflows equivalent to December 2008. All the more astonishing as the S&P 500 is hundreds of points higher.

This is simply astonishing. What exactly does a stock market have to do to get some respect around here?

Bullish
There are two ways we could look at this. If you’re bullish, you would say that the fact that the retail investor (or “dumb money”) has not jumped on the bull market bandwagon means that this is the real deal. After all, secular bull markets are known for pulling out of the station and leaving all but the most savvy investors and traders behind. And as contrarians, we want to zig where the crowd is zagging. So let them shiver, coiled in the fetus position, terrified of the last (and past) bear market. This is a new dawn. A new day.

Bearish
On the other hand, if you are bearish, you would point out that retail participation is vital to create momentum in a trend. Unless the US retail mutual fund investors start to believe in a bull market, there won’t be a bull market. After all, if the considerable amount of money sitting in fixed income is not used to bid up equity prices, how will we create the virtuous cycle of higher prices (which pulls in more money and so on)? Every secular bull market feeds on this self-perpetuating mechanism.

Could it be that this bear market left a traumatic mark on the psyche of the average US investor? If so, then this generation of investors will simply not be the same. We know from previous brutal bear markets that while the wounds heal, the scars are not forgotten. The generation that lived through the Great Depression continued to distrust banks, the stock market and all manner of ’speculation’ even after the US economy righted itself and went on to new heights of prosperity.

Let me know what you think
In any case, those are my thoughts. What do you think accounts for this aberrant behavior of the US mutual fund investor?

Here is the sentiment summary for this shortened holiday week (Happy belated Canada day and 4th of July!):

Investors Intelligence
Stock newsletter editors were on average unchanged from last week: bulls 41.4% and bears 29.9%.

AAII
The weekly retail investor sentiment survey from AAII shows a sudden jump in optimism: the bulls came in at 38% - a 10% point jump from last week. While the bears are 45% of respondents, a drop of 4% points from last week.

It is difficult to parse the meaning of this move back and forth. First much more bearish, now decidedly less so. Since we didn’t really reach any levels of historical significance with this sentiment indicator, the only thing we can safely say is that retail investors are skittish but not despondent.

Barron’s Confidence Index
This is among Richard Russell’s favorite indicators. The Barron’s Confidence Index is a ratio between Barron’s high-grade corporate bond index and Barron’s intermediate-grade corporate bond index. So basically it shows how much or how little demand there is in the more speculative, lower grade bond market.

The lower the Confidence Index, the less inclined people are to accept risk in the bond market and the higher, the more they are willing to take on risk. Historically 60 has been considered an extremely low level. But as you can see, we easily sliced through that level during last year’s credit market turmoil:

Source: Plexus Asset Management

But since the low late last year, the credit market has improved and we are now trying to return to normalcy. There is a high correlation between this indicator and the equity markets, which is why Russell follows it so keenly. It can be considered a good proxy not only for the bond sentiment but for the over all appetite for risk. There are many indications which confirm this point of view, for example the return to earth of the TED spread.

You can follow the indicator by rifling through the pages of Barron’s print edition or you can alternatively find it online.

Magazine Cover Indicator
This week’s magazine cover sentiment comes courtesy of Business Week, purveyor of many fine contrarian cover indicators in the past. This week’s cover asks:

Can You Afford to Retire?
After watching their savings evaporate and their net worth plunge, many are giving up on retirement planning.

The graphics is a clever play on the falling stock market, in a thick red line… which transforms into a beach lounge chair.

On the whole it isn’t ’slash your wrists’ or ‘Death of Equities’ gloomy but you have to wonder if this kind of cover would have even been contemplated in 2007.

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.

AAII
The retail investors as measured by the American Association of Individual Investor’s weekly sentiment survey are astonishingly pessimistic: 54% bearish.

To find a more gloomy view from the retail investor’s camp we’d have to go back to mid January when the AAII sentiment reached 59% bearish.

Back then I showed you this chart:

We have definitely seen 13 weeks pass since then and within a few more weeks will also complete 26 weeks. But unlike the historic average shown in the bar chart above, the market has yet to hold a decisive rally.

The S&P 500 Index (SPX) did momentarily reach a high of 1440 but couldn’t hold on to it. For most of the time we’ve been trading below the levels at which we first saw a +50% bearish AAII sentiment. As I’ve outlined before, sentiment during a bear market is a different beast.

Hulbert Newsletter Sentiment
Mark Hulbert is worried that while we may have put in a significant bottom with the March low, it may not hold. According to the Hulbert Stock Newsletter Sentiment Index (HSNSI) the average exposure recommended is a paltry 2.2%. And while this is low, back in early March the average newsletter editor was downright panicking with a -29.2% exposure - meaning actually being short the market with almost a third of total portfolio allocation.

As we head into a possible retest, it isn’t reassuring to see sentiment sitting so much above those levels. The ideal sentiment that would catapult us higher would be an even more intense panic with the kind of market weakness we’ve seen. While that may change anytime, the HSNSI doesn’t reflect that right now.

Investor’s Intelligence
No significant change in this sentiment measure: bullss dropped from 44.8% to 43% and bears increased slightly from 31.1% to 32.6%. It isn’t offering much of an edge as it sits in lukewarm waters similar to the Hulbert analysis.

CBOE Put Call Ratio
While the traditional put call ratio (equity only) did rise during the turmoil of this week, we didn’t see it reach or exceed the important 1.0 milestone. In fact, it only was able to muster a high of 0.84 on Wednesday. That reflects a good amount of fear but just not enough to carve out an important inflection point.

ISEE Sentiment
This past Wednesday and Thursday the ISEE Sentiment measure fell to 74 and 75 - the lowest since mid March low this measure reached 56 (March 10th 2008).

Remember, the ISEE sentiment numbers are calculated differently from the CBOE put call ratio. For one, the ratio is inverted with calls as the numerator and puts as the denominator. Further, the ISE only uses options which are traded by non-market makers, stripping out the noise and showing what retail and institutional traders are doing. And lastly, the ISE data is for opening orders only.

All in all, a much more robust and useful measure of options trading sentiment.

Rydex Traders
According to Jason Goepfert:

Rydex traders had finally started focusing on “safe” funds more than “risky” funds - a stark change from earlier in May when they were five times more likely to trade a risky fund than a safe one. As of yesterday, the ratio fell under 0.5, meaning that those folks were more than twice as likely to trade a safe fund than a risky one.

Conclusion
Since I eschew using a single indicator to light the way, the weight of the indicators are confusing with many cross currents pulling me in different directions. The troubling and somewhat muddy sentiment outlook doesn’t help. Hopefully things will resolve themselves soon and the picture will become clearer.

This week the markets were propelled ahead by the positive earnings of major tech companies like Intel (INTC) and Google (GOOG). Here is the sentiment summary:

Sentiment Surveys
Investor’s Intelligence results are basically unchanged so no need to delve into them. The AAII survey this week shows a reemergence of bearishness with 49% of respondents in that camp (only 30% are bullish). This is rather odd because the market has continued to go higher but part of the mysterious gloominess of the retail investor may be that the survey was completed on Thursday, before Friday’s powerful rally.

In any case, as a contrarian and a current long, I always welcome pessimism, especially when it is accompanied by higher prices.

Market Breadth
With the rise in market prices, the percentage of stocks above moving averages has also increased. The shortest time frame I use is the 10 day moving average and it now shows about 82%, very close to levels which have pushed back rallies in the past. This is where we found this indicator last October when most indexes created their swing highs.

Chart from indexindicators.com

But is is a very short term metric which doesn’t preclude the market from rising higher in longer time frames. More importantly, the percentage of S&P 500 stocks above their 50 day and 200 day moving averages are 71% and 40%, respectively. The most important is the longer metric which is still very low.

It reached eye popping lows of 15% in January and again in March 2008. We haven’t seen numbers that low since the darkest days of the last bear market. This was one of the reasons I was unapologetically bullish. As I’ve brought to your attention repeatedly, such extremely low breadth numbers have always marked the start of a new bull run.

But right now, we’re a tiny bit over extended and I wouldn’t be surprised to see the market yet again pause and/or be rebuffed at the 1400 level which has turned it back 3 previous times. The difference now is that there are more and more stocks participating in the rally, as can be seen by the number of stocks above their 200 day averages.

CBOE Put Call Ratio
After spiking higher than 1.30 the CBOE equity only put call ratio backed off this week in a hurry, falling below 0.59 - this is the lowest number since early February 2008. And yet another short term argument for the tape to run into resistance.