Trader’s Narrative

Here is this past week’s important sentiment data:

Stock Timing Newsletters
The Hulbert Stock Newsletter Sentiment Index (HSNSI) was at 27.5% at the start of the week. Meaning that the average stock timing newsletter was recommending to their readers that they be long the equity market with 27.5% of their portfolio. This is where they were the previous week, before the powerhouse performance that the stock market put in rocketing higher with 90-90 up days.

So from a relative point of view, that performance did nothing to impress the average stock timing newsletter editor. This is bullish from a contrarian point of view. On an absolute level however, the HSNSI is well above the -29.4% it reached in mid March 2008. But it isn’t yet yet high enough to give me concern.

AAII
The weekly American Association of Individual Investors sentiment survey has suddenly veered sharply into a bearish stance. It wasn’t that long ago that we had more than 50% of respondents in a bearish posture, but now that number has withered to only 28%. To find a time when the AAII survey was more bearish we’d have to go back to October 2007 when the market made its swing high.

Although it is just one measure of sentiment, it makes me uneasy. I’m glad that I’ve already reigned in my enthusiasm.

ISEE Sentiment
Inside last week’s sentiment overview I mentioned that the CBOE equity only put call ratio had declined to dangerous levels (for the bulls that is). That is confirmed by the ISE sentiment data.

On Monday it reached a high of 158 - meaning that retail option traders were buying to open 158 call options for each 100 put options. It has since fallen to 117 on Friday and the 10 day moving average is still fairly low but still, it does give me another reason to be cautious here.

Insider Buying
I’m talking about the legal variety here, the kind that is communicated to the SEC and tracked by various services like Vickers/Argus and Insider Insights. Insiders have been actively buying during the markets most recent fall. Since insiders have an intimate knowledge of their market and businesses this is a big positive sign. On the other hand, had they instead sold en masse while the market fell, it would mean that we were not close to a bottom and had more to go.

According to Argus’ data for the past two months, insider selling to buying is 1.40:1 - meaning that for every $1.40 equivalent sold by an insider during that time, $1 was spent on buying stocks. Since insiders are normally net sellers, any decrease in this ratio is what matters. According to Argus, it is bullish anytime insiders are selling less than twice what they buy.

To add another to the set of indicators that compare the present market conditions to those of the end of the 2002 bear market, the current insider ratio is very similar to what it was then.

Conclusion
So while in the medium to long term, the viability of a continuing rally is still looking pretty good, there are gathering signs that we may backtrack a little or pause before fully exploiting it.

Here’s this past week’s sentiment data:

Sentiment Surveys
Investor’s Intelligence (measuring the newsletter editors market bias) is showing a surprising amount of bullishness at 56.5%. This is a slight increase from last week. The II bears fell slightly to 22.4%.

In contrast to newsletter editors, the AAII survey (measuring retail investors) is showing only 36% bulls and 47% bears. Since last week the bears increased by approximately the same amount the AAII bulls decreased.

Although odd, this isn’t the first time these two sentiment surveys have been at loggerheads with each other.

Fund Flows
According to AMG Data, US mutual fund investors withdrew $15+ Billion from equity mutual funds (not including ETFs). Most of that was from domestic funds and the remaining from foreign funds.

This is HUGE!! I can’t really understand what is going on or even if this statistic is correct. If it is, it is larger than any weekly withdrawal for more than 6 years. It is even larger than what we saw in the darkest days of the 2002 bear market. Wow!

Some portion of this gargantuan number is due to the year end effect when mutual fund investors have their last opportunity to square things tax-wise. But as I already pointed out, this is nothing like we’ve seen in previous year end tax selling. Something big is going on. Obviously when people are selling their equity investments at such a torrent, it is wiser to exit the crowd or even fade it.

State Street Investor Confidence:

State Street is one of the largest financial firms in the world. They have a unique sentiment measure which relies on aggregate data from their position as custodians for investment managers:

Unlike other survey-based confidence measures that focus on expectations for future prices and returns, the Index provides a quantitative measure of the actual and changing levels of risk contained in investment portfolios representing about 15% of the world’s tradable assets.

The interesting thing is that this month, the State Street Investor Confidence Index plumbed depths which it had never seen in its entire history!

If you want to get more info on this sentiment indicator as well as full historical data (monthly), check out the FREE Trading Resource section (under Reports & Articles). While you’re there, be careful or you might find other interesting stuff to busy you for hours

Alright, so by now we know that the ISE sentiment data on the official webpage is wrong. Thankfully I was able to correct it as best as possible. It helped that only the past few data points are suspect.

In any case, seeing how the ISE sentiment helped me turn cautious just at the top of this market swing, I’m not giving up on it yet.

But I’m reduced to using my own graph (see below) as their’s is wrong (and still neither corrected nor noted as such). Sheesh. I hope they get their act together. So the chart uses correct data (as far as I can be sure) not that crazy 51 data point.

I looked at the 10 day moving average as my guide, just as before. This time however this short term moving average is saying that the ISE sentiment index is about as low as it has been. Other than the March 2007 bottom, to find a similarly low reading we’d have to go back to the end of the bear market.

I’d still like to see atleast one day of major capitulation showing up on the ratio. Something in the range of 50-60. And atlhough we may get it, it may not be necessary. Rather than a whoosh down which has been the script so far, we could just meander and muddle through for a bit as people are bored to death rather than scared to death.

Click To Enlarge Graph:

Thin green line is the 10 day moving average of the ISE Sentiment Index while the thick blue line is evryone’s favourite market proxy.

The trend in the fund flows data continues. Investors are shunning the US stock market and embracing the international equity markets.

According to AMG Data: for the month of May 2007, domestic funds reported an outflow of $5.2 billion while non-domestic funds report net inflows of $11.6 billion.

For the month of June 2007, domestic funds report net outflows of $4.2 billion while non-domestic funds report net inflows of $9.3 billion.

The only other market which is even close to as unloved as the US is the Japanese market. Every other market, emerging and developed gets some love (aka capital).

While this dovetails nicely with the other data suggesting the retail investor’s apathy towards the US stock market, in the long run it can’t be good. Typically, a bull market starts out with everyone being skeptical and ends when no one is.

But the market needs the participation of the regular guy. Right now we are seeing the “smart money”, commercials falling over themselves to get long. This is a fantastic vote of confidence in the intermediate to long term. But they can’t sustain the market forever.

The International Securities Exchange is a relative newcomer to the options market. It offers an all electronic market and has used the leverage of technology to alter the landscape of options trading. The ISE offers one of the most most level playing fields for retail traders. With a growing amount of trading volume the ISE has become an alternative source of options sentiment data.

Most are familiar with the CBOE put/call ratio. But the ISE’s sentiment index is a little bit different. Here’s their own explanation:

“The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.”

Instead of dividing puts by calls and showing the results as a number, like, say 1.0045, the ISEE shows the number of calls traded for every 100 puts. So when you have a number less than 100, it means that more traders have opened long put options than long call options.

Because the ISEE excludes market makers, and because it only shows opening positions, it presents a fairly accurate measure of sentiment.

During the last intermediate market bottom, there were 3 days where we saw very pessimistic readings on the ISEE. On March 8th 2007, there were 58 calls traded for 100 puts. And on the day before and day after, the ISEE also showed very low readings:

In fact, the reading we saw in March was the lowest in the history of the ISEE (see table below). By contrast, last week, we saw a fairly low reading of 74. But it wasn’t even close to the previous market low. Here are the lowest 20 readings of the ISEE. Also, I’ve included the top 10 daily decreases and increases in daily ISEE readings: