Trader’s Narrative

At the start of the week we contrasted the strange pessimism that has gripped the US retail investor to the levitation act of Wall Street. It is almost as if Wall Street threw a party and other than institutional investors, a few day traders and algo quant jocks jamming high frequency trades, no one else showed up. If you ask Paul Desmond, of Lowry Research, this is a real bull market that will last another 3 years.

With all due respect to Desmond, today I wanted to entertain some bearish counter arguments to temper that cheery outlook and delve a little deeper into the market condition both in the short and longer term.

While considering the same ICI fund flow data, it is conceivable to come to bearish conclusions. Take for instance the fact that domestic equity funds have attracted less than $8 billion of fresh capital since the lows in March. Had this rally provoked the same pattern of retail investor participation as previous ones, we should have seen $150 billion flow to equity mutual funds, according to TrimTabs.

Maxims ad Nauseum
While it has become an accepted maxim repeated ad nauseum that a bull market likes to climb a “wall of worry”, the historical evidence is otherwise. The stock market actually tends to float higher on gradually increasing levels of optimism - until that optimism reaches a crescendo and then the whole thing unwinds. And we start all over again. So generally speaking, the stock market performs better following periods where there are net inflows of funds.

Whether retail investors are acting intelligently by avoiding this rally or more accurately, by selling this rally, is something that only history can answer. It isn’t hard to imagine though, the possibility that they are reacting emotionally. Think of it. Having first experienced severe loss in their portfolios and watching Wall St. insiders ride on a cushion of bonuses, insult is added to injury when they have to fend for themselves in a new harsh economy.

What if we are seeing the rejection of the great “equity culture” and the almost religious belief in “buy and hold”? What if the record inflows to bond funds are being driven by a traumatized populace seeking the one shelter of income investing?

So far, this has been so relentless that it has pushed the fixed income share of US household wealth above 6% once again. But if you notice, the last time there was a similar increase happened during one of the strongest bull markets in equities:

However, what is undeniable is that if the US retail investor doesn’t return to equities eventually, what we could see is another lost decade; where markets flop around like a dead fish, but don’t really go anywhere. This is what happened before the great super-bull market was launched in 1982.

The completely stark scenario is one where retail investors continue to ratchet up their sales of equities and push the stock market lower as a cascade effect takes place where gloomy sentiment and fear feeds on itself. Think of it as the great unwinding; or the negative wealth effect.

Technical Weakness
Returning to more present and short term matters, the market came perilously close to the invisible 20% distance from its long term moving average. Yesterday I mentioned that stocks have little room to the upside and while I’m not surprised to see the weakness today, it by no means guarantees that we won’t see a final push to 1120.

On Monday 94% of the S&P 500 stocks closed above their 10 day moving average. That’s the highest since mid July. Since then this measure of breadth has backed off slightly but is still hovering above 90%. Other negative technical considerations are that prices are pressing against the downtrend line at 1100 - from the top of the bear market (in October 2007). And that other major market indexes like the Nasdaq, Russell 2000, the Philadelphia Banking Index (BKX) and the Semiconductors (SOX) are still below their previous swing highs. Finally, volume continues to be anemic as it has been for most of this whole trip.

Here is the round up of sentiment data for this week:

Sentiment Surveys
According to the weekly AAII sentiment survey, US retail investors are pretty much split evenly between the bullish and bearish camps. The bulls are at 42% ( that’s a 5% point increase from last week) while the bears are at 40% (4% point decrease from last week).

ChartCraft’s Investor Intelligence measure of stock newsletter editors has taken the bullish mantle from the retail investor’s survey for several weeks now. And it continues this week as well. The latest II poll shows the bulls commanding a 47.8% share of the respondents (down slightly from last week) and the bulls, 24.4%. The simple bear/bull ratio continues to run at about 2:1 - giving contrarians a clear signal.

German ZEW Survey of Investor Confidence
Turning our attention to the other side of the pond, the German ZEW sentiment survey of investor confidence (green line in chart below) came in slighly short of the 60 expectation but still managed to climb to 57.7 - its most bullish level since April 2006. However, the survey’s “current economic” outlook - while slightly off its recent lows - is still mired at historic depths (blue line):

This month’s survey results mark one of the few times in the history of this statistic where there is a large mismatch between the two measures. While the current economic situation is still deemed to be very poor, confidence in the future is very high. This should be familiar as it is the same tune that everyone is humming in the US markets. The question then is what happens if the rosy expectations of the future do not come about?

Option Traders
Both the CBOE put call ratio and the ISEE index are showing an excessive bullishness. This should be normal but since they have disagreed with one another so much, it made me sit up and take notice.

The CBOE put call ratio (equity only) dropped to a low of 0.45 earlier in the week (Wednesday - September 16th, 2009). That’s a lot of call buying! The short term moving average of the daily put call ratio continued to decline as it has for the past few months. It is already below its long term channel so it is difficult to determine what if any sort of signal it is giving now.

The ISEE index (equity only) meanwhile jumped to 242 on Wednesday’s long range candlestick. That means for every 100 puts, 242 calls were bought (to initiate a position). To find a more bullish one day statistic, we’d have to hop into our time machine and travel back to November 6th, 2007 when the ISEE index hit 245. At that time the S&P 500 was trading around the 1500 level. More important than just the one day spike, the 10 day moving average for the ISEE is now also significantly high as shown on the chart below:
Continue reading ‘Sentiment Overview: Week Of September 18th, 2009′

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Welcome to 2009 and the first trading day of the new year!

The last sentiment overview of 2008 didn’t paint a pretty picture. And it seems that things have continued to deteriorate from there.

CBOE Put Call Ratio
Here’s a chart of the 15 day simple moving average of the CBOE put call ratio (equity only):

Unless you zoom out you will miss that in the past few years this indicator has fallen into a rather clear upward channel. In light of this channel, we are now very close to a bearish low for the put call ratio. As you can see, in the past this has coincided with very weak markets going forward.

ISE Sentiment
Surprisingly, just before the stock market got a year end boost - the S&P 500 rising from 870 to 930 - the ISE Sentiment index reached 206 on December 29th 2008.

The last time the ISE Sentiment index was close to this level was back on October 29th 2007 when it reached 192. Before that, the last time the call put ratio was above 200 was in May 2006, just before the market entered a period of weakness lasting until October of the same year.

If we look at the equity only ISE Sentiment data, the recent top came on the second to last day of trading of the year, on December 30th 2008 when it reached 234 - meaning that retail option traders on the ISE exchange bought over twice as many call options as put options. The last time this bearish level was surpassed was in October 2007. So obviously this is an ominous warning for anyone who is long this market.

Here’s a chart of the ISEE sentiment ratio (equity only):

Silver Lining
The only bright spot I can find in sentiment land is the recent data regarding portfolio allocation from the AAII. I’ve mentioned this before back in the sentiment overview for the week of October 3rd 2008.

According to the survey respondents at AAII, in October of last year, the retail investor in the US allocated 35% in cash, 51% equities and the rest in bonds. They have now moved to 42% cash and only 42% equities (and the rest in bonds).

This is significant because for the whole history of this indicator, retail investors have never allocated as much (or more) cash as equities. Clearly, this shows a despondency which contrarian investors spend most of their days sighing for in vain.

Although we have now surpassed any historical equivalent of an extreme for this sentiment indicator, it is interesting to note that the last two times that the allocation for cash and equities came close (but didn’t match) was in late 1990 and late 2002. Both brilliant spots to put cash to good use.

This dovetails well with some other reasons already outlined for long term optimism. It seems that we are in for a rough patch in the short term but clear sailing for those who will grit their teeth and bear it. No pun intended

Ticker Sense’s blogger sentiment poll is one of the lesser known sentiment measures so you’re forgiven if you aren’t familiar with it. The most recent survey results, from October 13th, show that there are no bears. Zero. None. Zilch. Three quarters are bullish while the rest are neutral or can’t make up their minds.

According to contrarian analysis, this might be a negative sign. Or maybe it is a bullish sign. After all, shouldn’t these people be “experts”? If they parse the market on a daily basis, invest and trade regularly, shouldn’t they have a better idea than the average person out there?

So does the runaway bullishness in this week’s sentiment survey mean that we should sell? or buy?

Neither.

I looked at it as a sentiment metric last year and found that as it turns out the Ticker Sense blogger sentiment survey offers no edge at all:

The conclusion I draw is that the poll is simply meaningless. It provides no significant piece of sentiment information we can use. At times it is bullish and at most other times bearish. But there is no connection whatsoever with the market.

This latest data point is the highest bullishness but I don’t think it really makes any difference. According to its past, the survey can not be used as either a contrarian measure nor as a straight indicator of any kind. Honestly, I’m really surprised that the folks at Ticker Sense are continuing this survey.

As you were.

Depending on the framework you use to understand the market, at times it is possible for the market to be “confused” or even “wrong”. Of course, according to some, the market is the perfect amalgam of all relevant information so that isn’t possible.

But then again, any student of the financial markets can easily call up many examples where the market exhibited what can perhaps be best described as collective temporary insanity.

As I look across this market, checking the advance decline breadth, the highs and lows, the VIX, put call ratios, and all the other technical indicators, I can’t shake the feeling that it is a bit confused. Or perhaps, it just can’t make up its mind and is trying to hedge its bets as best as possible.

Just look at the past few trading days! Up, down, up, down, up, down… ending up at pretty much the same place we started.

I’ve been accused of having a penchant for the bullish side so I’m trying to be more than careful in scrutinizing the weight of the evidence, on both sides. And for the most part, there is really no compelling reason to be in either camp right now.

Maybe (gasp) the retail investors are right and cash is the best spot right now.

The market certainly feels heavy, but while intuitively I think it wants to go down, I don’t see any strong reasons to push it down with my own measly contributions.

Here is a snapshot of the sort of thing I mean. This chart shows the percentage of S&P 500 stocks trading above their 10 day moving average. Notice how in mid July, as the market was pulled sharply lower, this very reliable indicator (check out the research report from Lowry’s), did not perform its usual magic:

Is it too much of an obvious to say that this market is being driven by the financials? They were responsible for the mid July spike down in the behemoth S&P 500 Index. Pull up a chart of the 90 day Treasury Bill and you can see the epicenter of the quake that shook the markets.

I’ll go more in depth in tomorrow’s weekly sentiment overview and we’ll see if we can make any sense out of this crazy tape.