Trader’s Narrative

The market got spooked today because of the release of the Fed minutes (April 30th meeting) showed a hawkish bent. First, I don’t think the market fell because of that. I’ve been cautious for a while now due to a number of technical and sentiment indicators.

But the reluctance of the Fed to continue cutting may not be a bad thing. For one, take a look at the comparison between the Fed Funds rate and the 3 month Treasury bill rate:

It is like the reunion of two lovers (this is as romantic as a trading blog can get). These two financial metrics usually go hand in hand but for far too long there has been a historic dislocation between them. I first pointed this out last summer: Fed should cut rates immediately.

The fact that now we are seeing the bond market and the Fed Funds rate return to their normal behavior bodes well. Especially considering the financial turmoil we’ve endured so far. Believe it or not, at one point they were 133 basis points apart!

And now we are down to just 14 basis points.

I know this is a very simplistic way of looking at an incredibly complex matter but what can I say? I like simple things. I prefer to allow the market’s voice, through the 3 month T-Bill rate, show me where the interest rate should be. I definitely think they do a much better job than a committee of economists harrumphing around an oak table.

I would have preferred the Fed to have taken the rate below, even if just a smattering, the bond market set rate. But I doubt that will happen. We can just settle for the fact that instead of the previous pattern of running away from the Fed, the bond market is now heading towards it in what seems an inevitable reunion or perhaps, even
a crossing.

After almost two years of estrangement, that calls for a celebration.

My continued bullishness may be seen by some as stubborn, but after looking at the sentiment out there, what other position can you take?

Option Traders Freak Out
The ISEE index recovered from a low of 60 - a low enough level to show severe panic in retail option traders. Although we don’t have long term data for this ratio, the data that we do have indicates that this is low enough to stoke a rally or at least halt a decline.

The more traditional CBOE (equity only) put call ratio once again came in near 1.0 today - this is the third time this week that it has been above or just at parity. In the past 4 years, we’ve only seen parity broken a handful of times. But to see a grouping of such high put call ratios is highly unusual.

I think it is safe to say that option traders, and especially the least experience and least capitalized of them (retail) are in full freak out mode:

Sentiment Surveys
The only traditional sentiment measure that is not showing excessive bearishness is Investor’s Intelligence with 45.6% bulls and 26.7% bears. A few people have asked me about the disparity between it and other sentiment indicators. Honestly I don’t know what is really going on but as I’ve said before, you have to understand that it is very different from other measures.

For one, newsletter writers are a generally more optimistic bunch (since bullishness sells better than its counterpart). Second, II is tabulated through the subjective thinking of one person, Michael Burke. He categorizes newsletters as either bulls, bears or neutral from not necessarily their portfolios but also what the writer is saying. Since the newsletters can’t themselves, in effect, “vote”, this measure is open to the personal bias of one person.

So maybe that explains the discrepancy or maybe it doesn’t. In the end, it is one measure among many. I’d rather take the general judgement of the group, than single out any one of them.

LowRisk’s recent 30 day outlook is decidedly gloomy with 56% bearish and 32% bullish. Market Vane’s bullish percent dropped to 48% and although that sounds too high already to be bullish, you have to consider that for the past 4 years, it has oscillated between 75% and 55%. Likewise, Consensus‘ bullishness is at 47%.

AAII is showing panic-level bearishness again with 54% bears and only 24% bulls. Check out last week’s chart to see the correlation between such high bearish AAII sentiment and stock market performance.

According to Jason Goepfert, waiting two weeks after a bearish percentage above 50% gives us a better chance of finding a winning trade: 24 from 29 instances with an average return of +3.1% (over two months). He also says that the “average drawdown (i.e. maximum loss) of -3.2% was dwarfed by the average maximum gain during the trades of +5.7%.”

Rydex Ursa/Nova Ratio
Before leveraged ETFs, the only way retail traders got long or short aggressively was through the Rydex Nova/Ursa funds. Although they have become somewhat of an anachronism, their ratio is still useful to show the retail investor’s mood.

Not surprisingly, we are seeing a dash into the bearish leveraged fund (Ursa) as the “dumb money” goes into panic over the recent market losses.

I was busy on Friday and couldn’t post this at the usual time. Here is the weekly sentiment roundup:

Sentiment Surveys
Fear gripped the respondents to the AAII survey last week as bullishness plunged to 26% (from a recent high of 47.62%) and the bears, meanwhile, catapulted to 55%. Whenever we’ve seen this much bearishness, it has been a good time to buy. Click here to see a chart of what the S&P 500 does historically after similar AAII readings.

Surprisingly, the Investor’s Intelligence survey (which is one person’s judgment on the sentiment of newsletter writers) shows the opposite: 52.2% bullish and only 24.5% bearish. Personally, I’d rather go with the gauge that relies on the response of thousands (instead of one). Especially as the other sentiment indicators dove tail it so well.

(Mutual) Fund Flows
Data from TrimTabs corroborates the shocking hemorrhage in the mutual fund industry I wrote about before. According to them, 2007 saw probably the largest outflow in history.

I still have no idea what is going on here. And it is a bit strange that no one is really talking about this in the media. It does fit in with the retail investor’s sentiment and from a contrarian point of view, it is very bullish. Take a look at this graph sent in by a reader. It puts this into historical context:

Click to Enlarge

Option Traders
Last week, before the market sold off, I wrote a cautionary post: Retail Option Traders Tad Too Giddy. And right on cue we saw the result of that “giddiness”.

Option traders have backed off, a bit. The CBOE put/call ratio is now almost 0.7. And the retail traders, as measured by the ISE Index, dropped from 168 to 93. These are not “buy zone” levels but as the market digests the loss over the weekend, I think we will see an expansion of the panic that seems to have started - which will provide those levels.

Insider Buying
The legal kind, is off the charts. According to various sources that track what corporate insiders are doing, they are scooping up shares hand over fist. They’ve been on a buying spree pretty much since last summer and have never become net sellers (yet).

Commitment of Traders
The commercial players in the futures market (the most well funded and knowledgeable of the bunch) have significantly stepped back from the record COT net long position they had last summer. The best I can say is that things aren’t as wildly bullish as then. But they are somewhere near the middle - no where near net short.

Everyone these days pays at least some attention to sentiment. Which means that the usual sentiment indicators run the risk of becoming saturated with attention, and therefore less effective.

Which is why I love finding novel ways of measuring sentiment. One that I’ve already written about is the “sheeple index” which is a measure of retail broker’s web traffic.

Another indicator is to measure the level of interest that people have in specific internet searches. For example, using Google Trends, we can see a history of people searching for “stock market crash”:

Since people would have to be really bearish to even think of typing in such a search string, it may have value from a contrarian point of view. As you can see each time there was a spike high in the number of searches for “stock market crash”, it was a great time to actually go long!

And here’s the chart for the keyword: “subprime”:

Again, note that the two spike highs correpond to intermediate bottoms in the market.

What about you? Do you have an unorthodox way of measuring market sentiment?