Trader’s Narrative

If it is Friday then this is the week’s sentiment round up:

Sentiment Surveys
If you’ve been monitoring the mutual fund flow data, you wouldn’t be surprised to see the AAII continue to show the average US retail investor as decidedly unimpressed and cool about the rising stock market. This week the pessimist camp grew slightly to 41% while the bulls shrank by 9% points to 35%.

The latest Investors Intelligence bulls edged off the half way mark to 48.9% while the bears increased slightly to 24.4%. This is nothing really noteworthy by itself, except to mark the continued 2:1 bull to bear ratio we’ve been seeing for the nth week. So far, the market has not succumbed to this flashing red light and it is anyone’s guess when it will finally decide to do so.

I mentioned the NAAIM Survey of Manager Sentiment as a lesser known sentiment measure at the start of the year. And it is time we updated it to see what it can tell us about the mood of active investment managers in the US:

At the end of September the NAAIM was +86.41 and has since dropped slightly to 68. It is difficult to see in the chart above, but the last time this sentiment measure showed as much bullishness was back in - Yikes! - October 17th 2007 (when it was +86.93). And it was surprisingly, even higher earlier in that year when it reached +90 in January, February and May 2007.

The RBC Consumer Attitudes and Spending by Household (CASH) survey jumped 11.8 points to 51.8 in October - this, after falling to an all time low of 1.6 in February 2009. The monthly RBC Index measures consumer attitudes on the current and future state of local economies, personal finance situations, as well as their savings and confidence to make large investments.

Finally, Consensus which measures futures traders shows them to be 72% bullish. Once again, raising the hairs on your back, that’s the highest level since October 2007.

Option Traders
The puts and calls are flying furiously but there is a definite skew as option traders favor the bullish side of the derivatives. Both the ISE and the CBOE measures of option activity show a continuing crowding on the long side.

The ISE sentiment index (equity only) closed at 221 this Friday, implying that more than twice as many calls were purchased to open a trade as puts. Meanwhile, the CBOE (equity only) put call ratio fell to 0.47 on Tuesday - among the lowest single day ratios for the whole year… so far.

Rydex Traders
But the itchy trigger fingered Rydex traders have suddenly gotten cold feet. Even as the market has recovered smartly from its latest set back, the Rydex Nova/Ursa ratio has fallen as these short term market timers eschew the long side:

Conclusion.
Cross currents in sentiment are completely normal and something that any contrarian has to get used to. However, the current market’s sentiment conditions are especially confusing as it seems that one measure simply contradicts the one before it. When you don’t see an edge, don’t push your luck.

There’s much to cover in this week’s roundup of sentiment data, so let’s dive right in:

Sentiment Surveys
The American Association of Individual Investors’ weekly survey of sentiment doesn’t show much change. About 39% think the market will go higher - that’s 3% points less than last week - while 45% think the market will fall - that’s a 5% point increase from last week. All in all, the AAII survey hasn’t given us a signal definitive signal since August when it blinked red (excessive bullishness) and earlier in March when it blinked green for excessive bearishness.

The Investors Intelligence survey of newsletter editors on the other hand continues to insist that there are about twice as many bulls as bears: 46.7% bullish and 24.4% bearish. We’ve seen a gentle amelioration in the optimism from last month but still, 2:1 is rather extreme.

Since we’re slicing and dicing sentiment through various surveys, why not take a look at what the millionaires are thinking? The Spectrem Millionaire Investor Index and the Affluent Investor Index are the only one of their kind (if I’m wrong, let me know). Few wealthy investors are ready to jump back into the stock market. Right now they are fond of cash and growing fonder of bonds. While still very cautious towards equities, they have started to tip-toe back in. According to Spectrem, 70% believe a drop in unemployment will signal the end of the recession. So it seems the wealthy are not all that different from the unwashed masses - at least when it comes to their portfolio.

Michigan/Reuters Consumer Confidence
US consumer confidence continued to rise reaching 73.5 - much higher than the expected 70.5. This is the highest level of consumer confidence since January 2008 - before the equity and credit markets cascaded down in a devastating decline. The index of future expectations continued to recover as well, rising to 73 - the highest in 2 years.

This month’s Michigan/Reuters survey also provided for a very large jump in the “News Heard Index” which measures the ‘net’ bias of the good news and bad news that consumers hear. According to Credit Suisse’s chief economist, Neal Soss, the News Heard index has a very high correlation with monthly changes in consumer confidence. So maybe the US economy is starting to turn around. But even if it isn’t, if enough people believe it is, it becomes a self-fulfilling prophecy.

Rydex Traders: All In
This week’s weakness in the stock market has been enough to bring out the bargain buyers within the Rydex market timing community. Right now there are twice as many assets in the bullish side as the bearish side. Every time that we’ve seen this extreme in recent times, the market has either paused or corrected. For more information, see Guy’s blog: Technical Take.

Fund Flows Data
If you were reading the blog earlier this week, you caught the chart of equity vs. bond mutual fund flows. While it is still premature to label it a trend, the preliminary data shows that the average US retail investor is not being enticed to re-enter the stock market in the least. Not even by an astounding 57% recovery in the S&P 500. They are in fact withdrawing their money from equities and stuffing it in various bond funds. The anecdotal evidence points to a traumatized populace which has been burned so many times, it has simply decided to withdraw and not play a rigged game.

Other than the implications for stock market sentiment, which are many, this brings up another important point. Whatever the impetus for this rally, the mutual fund data suggests that the US retail investor is not it. So if the masses who were once weaned on “buy and hold” are not buying, and corporate insiders are not buying, who is exactly?

Option Traders
We patiently waited many months as the ISE and CBOE option data fed us mild gruel week after week. Now they are both showing excessive call buying as option traders push their luck that the stock market will continue to rise:

The short term average of the ISEE index (equity only) which measures retail call buying relative to put buying is now at 194. This means that on average almost twice as many calls were bought as puts to initiate a position by retail traders. The last time this indicator was at these lofty levels was in November 2007. The highest it reached during that cycle was 229 on October 15th 2007 just days after the bear market top.

And here is the chart for the 10 day moving average of the CBOE (equity only) put call ratio showing basically the same amount of excessive bullishness:

The confirmation that these two separate option sentiment indicators provides is welcomed, especially after so much time where they either disagreed with one another or didn’t flag any extremes at all. The message right now is crystal clear.

A few days ago we discussed the bearish implications of the S&P 500 being 20% above its 200 day moving average. A similar study from Quantifiable Edges based on the CBOE put call ratio data shows a similar outcome.

Gold Sentiment
Gold is once again flirting with the $1000 level. It has once again lost the four figure handle but from various sentiment indicators, we have good reason to expect this current charge to succeed in breaching the $1000 line for good.

The Hulbert Gold Newsletter Sentiment Index (HGNSI) is showing a surprising lack of excitement this time around in contrast to the other previous runs at $1000. The average exposure recommended by newsletters at previous tops was 62%. However, the HGNSI currently only stands at 39.5% (see article for more details).

The lukewarm HGNSI number dovetails with the other various sentiment indicators which I mentioned recently: Google Trends: Gold Sentiment Neutral and Various Perspectives On Gold At $1000.

Grey Beards
Let’s check in with the ‘grey beards’ - those that have either been prognosticating for a lengthy time or have been extremely prescient to win our admiration and attention. David Rosenberg continues to be unapologetically a non-believer in the current standing of the stock market. He recommends resource sectors, gold, other commodities and the Canadian dollar and Canadian government bonds.

The grumpy bear, Jim Grant has suddenly gone bullish. In a recent Wall Street Journal article Grant outlines his reasons for a more optimistic outlook.

Bob Janjuah of RBS is having none of it - as usual. He is back from vacation with a bah humbug!

All I see is growth and asset price gains driven by the willing and reckless destruction of government and central bank balance sheets.

Magazine Cover
From the contrarian perch, this week’s Business Week magazine cover is a confusing one. Because of the design, there are two covers in one that manages to be both bullish and bearish, depending on which side you hold up and read.

On one side it says: “Why the Market Will Keep Going Up” and on the other it says: “Why the Market is Going Nowhere”. Technically those two statements aren’t polar opposites. Had the negative one said “Why the Market Will Crash (Again)”, that would have been a truly contradictory statement. But then again, the stairs are leading down so maybe I’m over analyzing this. So, will the market go up or down? Yes.

The Evolution of Overconfidence
Finally, here is a fascinating article from MIT’s Technology Review about the evolutionary underpinnings behind the human propensity for overconfidence. Since it is an inherently a self-destructive behavior, how did we manage to survive and why is it part of us in the first place?

By creating a mathematical model of the way overconfident individuals compete against ordinary individuals, they show that there is a clear advantage in overconfidence.

In fact, if the potential reward is at least twice as great as the cost of competing, then overconfidence is the best strategy. In fact, overconfidence is actually advantageous on average, because it boosts ambition, resolve, morale, and persistence. In other words, overconfidence is the best way to maximize benefits over costs when risks are uncertain.

While that may be a neat and tidy explanation, the corollary is disturbing:

Their model implies that optimal overconfidence increases with the magnitude of uncertainty. So the greater the risk, the more overconfident individuals should become. Johnson and Fowler use that finding to predict that overconfidence will be particularly prevalent in domains where the perceived value of a prize sufficiently exceeds the expected costs of competing.

Sound familiar?

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Earlier in the week we looked at the situation the gold market finds itself in with the precious metal sitting at the important $1000 level. I offered various takes on the technical position as well as the sentiment for gold. Here I want to delve in a bit deeper into the sentiment to see if we can glean whether there is any excess optimism which would flag a contrarian sell signal.

Here is the Google Trends chart for the keywords “buy gold”:

Not surprisingly, the peak occurred in the week of October 5th 2008 (3.66). The keywords: “how to buy gold” also reached a peak a bit earlier on Sept 21st, 2008 (not shown in graph). That’s still around the same time. This was, of course, right around the time that the equity market was getting a shellacking.

The term “stock market crash” reached a peak in Google searches at the same time (October 5th 2008). But right now, while slightly elevated, this makeshift indicator isn’t really signaling an excessively speculative sentiment towards gold. Of course, this is noteworthy because gold is trading about 20% higher than it was in October 2008.

In my earlier analysis of the gold market, we looked at the Commitment of Traders report, MarketVane’s as well as the Hulbert Gold Newsletter sentiment indexes. Let’s take a quick look at several other measures of sentiment for gold:

Rydex Traders
Guy over at the Technical Take mentions the asset levels in the Rydex gold fund. While the Rydex investor is the trigger happy type to jump on a trend, either long or short, there is no evidence that they have piled on gold at this time. There is only about $200 million in the Rydex Precious Metals Fund. I agree with Guy, there is a distinctive lack of froth.

Put Call Ratio
The put/call ratio for gold is also in neutral territory. This is the options data on the futures contracts which is about as speculative as you can get considering the built in leverage. There was a slight uptick in call buying as gold made its latest move towards $1000 but even as that level has been pierced, the put/call ratio has backed off (traders are less optimistic).

Conclusion
The consensus from several different measures of gold sentiment is that there is mostly a shrug of the shoulders from traders and investors in reaction to the latest rally in gold. The only conflicting data point is the CoT report which shows small speculators in the futures market heavily long gold contracts.

The Dow Jones was in fine summer condition putting in the best July performance since 1989 and its best month since 2002. Are we in thin air territory yet? To find out, check out the sentiment summary for this past week:

AAII
After 6 weeks of the bears continuously trouncing the bulls in the AAII weekly sentiment poll - something we hadn’t seen since the low in March earlier this year! - the bulls are back. The most recent survey of retail investors shows that optimists rose 10% points to reach 48% and the bears fell 11% points to just 31%.

We need the retail investor to return to the stock market for there to be a real and prolonged recovery. But such a jump in sentiment is troubling. Previously it has not supported higher prices going forward.

Investors Intelligence
The percentage of bulls jumped to 42.4% and the bears decline to 31.1%. So we continue to see a healthy amount of optimism from the average stock newsletter editor, although not excessively so. And this week’s numbers take us back to where Investors Intelligence sentiment was at the beginning of this month - when the S&P 500 was trading some 110 points lower.

Money Market Cash Levels
Believe it or not, there is more than $3 trillion sloshing around in money market funds. But the nominal amount of funds isn’t really that helpful to us since just like GDP it continues to grow along with the economy. What is helpful in determining where we are in the big scheme of things is the movement between equity markets and money markets.

Obviously when investors are fearful, they sell anything and everything ‘risky’ and put their money in the protective but less lucrative vehicle of money market funds. That’s exactly what we saw in March of this year: Tsunami Of Cash Just Waiting To Be Invested. Unbelievably, the total assets of money market funds was higher than equity funds!

That has now returned to its normal historic ratio with total money market funds decreasing to just $3 trillion. But it isn’t only the return to the historical pattern that is noteworthy. What we’re seeing is not an orderly and mild shower of liquidity but a veritable tsunami as both retail and institutional investors move massive amounts of assets from cash. Not only are they moving record shattering amounts, they are doing so in just one month’s time. So whether this recent rally is the real thing or not, large and small players are reacting to it with the reflexes of a cobra.

While this may be interpreted as very bearish, you have to note that not every single dollar taken out of money market funds is automatically put in the equity market. In fact, only a small portion is destined there. Had every single dollar been invested in the stock market by the way, we would probably bee looking at the S&P 500 at least 30% higher from where it is. The rational take away from this measure then is that the participants in the financial markets are recovering from the shell shock they suffered earlier this year and late last year.

Option Traders
Yesterday when we briefly broke above 990 on the S&P 500 index, the CBOE put call ratio (equity only) hit 0.50 - that magically half point marker is significant because it shows the average option trader’s raucous disregard for risk as they reach for the long side. Historically, it takes the market a few days to digest this before reacting lower. However, the last time the put call ratio plumbed these depths was in mid-April, earlier this year. And it was totally ignored by the market on its merry way higher.

On Wednesday (July 27th 2009) the ISE sentiment index (equity only) reached 220. That’s the highest level since June 15, just before it started a protracted decline from the June swing highs. As well, we’ve seen several days of higher ISEE data so the 10 day moving average that I track has inched higher as well. The last time the short term moving average was around 170 was in early June, just as the market ran out of steam.

Rydex Market Timers
Traders in the Rydex family of mutual funds have once again reached for the stars. These are fast, market timers who switch between the Nova/Ursa (bull/bear) funds to make money on either side of the market. As a group, they are a good contrarian indicator when they reach an extreme. As they have now.

The last time they caused us to mind their positions was back in mid June 2009 when they had a herded into a bullishly lopsided extreme.

Insiders Selling
Corporate insiders are once again selling their own company’s shares at a pace that is alarming. According to Vickers Weekly Insider Report, more than 4 shares are being sold now for every 1 share bought by an insider. To find a higher ratio we need to go back to October 2007. While this may appear to be a bright, red blinking light, there’s more reason to treat it as a cautionary yellow.

That’s because insiders, for all their reputation, do not have such a great track record in timing their own shares. They obviously do have an edge on others but they aren’t perfect and certainly can be wrong. But more often than not, they are right but tend to act too early - by about a year.

Here’s the sentiment summary for this week’s trading:

Sentiment Surveys
According to the sentiment surveys, an alarming number of investors and market timers have returned to the long side. The weekly AAII retail investor sentiment survey shows 48% bulls (an increase of 8% points) and 37% bears (a decrease of 12% points). We haven’t seen this many bulls in the AAII survey since the first week of the year. As I’m sure you’ll recall, that was not a happy time for putting new money to work on the long side.

According to ChartCraft, the weekly Investors Intelligence newsletter sentiment survey shows 42.5% bulls and 25.3% bears. The S&P 500 ended the week 21 points higher (or 2.2%) so the market hasn’t really done anything to deserve such hope or devotion.

Barclays Capital Sentiment Survey
Barclays Capital said that only 17.5% of the 605 respondents to its quarterly sentiment survey believe that ‘risky assets’ have more room to rise. Those taking part in the survey were central banks, asset managers and hedge funds. The majority believe that the world economy will experience either a protracted slowdown or if it is in recovery now, it will falter once more (a “W” shaped recovery). Asked whether the spring rally was just a “bear market rally”, 60% agreed - indicating that there is still a lot of dry powder out there.

NAAIM
Along with most sentiment measures the NAAIM trend survey of managers has recovered since the spring lows. For more information on the metric check out: NAAIM Sentiment Survey.

Market Froth
We’ve seen a lightning fast return of speculative trading to the stock market. You can see it in the volume of ‘garbage’ stocks (trading below $5/share) and in the general willingness of most people to shrug off the dark foreboding sense they harbored just a few months ago that the end was nigh.

There is also mounting evidence from the Rydex fund flows that the trigger happy traders that use these securities to time the market are piling into the long side. This is the case for both leveraged and normal Rydex funds and has in the past marked either significant market tops or the start of a plateau. In either case, when there is so much lopsided optimism in Rydex mutual funds, it is a flashing red light for those long the market.

Magazine Cover
I have a gut feeling that this week’s Economist magazine cover should be framed somewhere for posterity. It is a graphic showing a Tyrannosaurus Rex made up of car parts, leaking oil (as if bleeding).

I can’t help but wonder, if by the time a magazine puts up something like this, have the auto industry sector reached a nadir?

And I’m not thinking that because the image is hyperbole but because it is a creative representation of the unvarnished truth. I’d prefer if it was on Newsweek or Time but we’ll see. I think this Economist cover is one we’ll come back to years from now.