Trader’s Narrative

Here’s an up and coming sentiment tool that I discovered recently. It is released weekly by the National Association of Active Investment Managers (NAAIM), a non-profit association of registered investment advisors formed in 1989. Since the (200 or so) member advisors provide active money management services to their clients, as opposed to buy and hold, they position their portfolios according to their opinions of the market’s future. In reality every portfolio is actively managed because there is no way to be passive.

In any case, each week on Wednesday, the advisors communicate their equity exposure by choosing one of the following answers:

• 200% — Leveraged Short
• 100% — Fully Short
• 0% — 100% Cash or Hedged to Market Neutral
• 100% — Fully Invested
• 200% — Leveraged Long

Their answers are then averaged to produce the NAAIM Trend Survey of Manager Sentiment:

Although we only have two and a half years of sentiment data and a relatively small sample size, this sentiment indicator shows promise. To start its extremes correspond to tops and bottoms in the S&P 500. For example, when active managers reduced their exposure to “neutral” in late August 2007 and July 2008, we saw the S&P 500 find its feet again.

But the latest active managers sentiment is somewhat troubling because even as the market weakness has continued for several months, they have positioned their portfolios more and more aggressively long. Once again we are seeing that we do not have a “wash-out” or complete capitulation. On the contrary, everyone it seems is even more hopeful… as the market falls even lower!

Although the NAAIM data is weekly, it comes out with a delay. The latest result is for January 14th 2009. I’ll update the chart when the new data is released or when it tells us some other interesting things about the market.

If you want to get more information or download the raw data to play around with it, you can do so at the NAAIM website.

Here is this week’s stock market sentiment overview:

Sentiment Surveys
In last week’s sentiment overview, ChartCraft’s Investor’s Intelligence sentiment survey came in at a 14 year low (for bullishness). This week there were only 22.4% bulls with bearishness remaining unchanged. This week’s numbers take the II to a 20 year record! From a contrarian point of view, the message is clear.

The AAII sentiment survey is whistling a different tune however. The bears fell dramatically from 61% to 40% and the bulls rose to 41%. That’s a dramatic shift. Not only for the decrease in bears but because technically we now have slightly more optimists than pessimists. For confirmation of a market bottom and a healthy rally, I’d prefer to see continued doom and gloom.

There was a similar uplift in mood for the Consensus sentiment survey. Bullish sentiment rose from last week’s 21% to 36%. Again, not the sort of thing that gives contrarians confidence for a sustainable rally.

Volatility
Now this is just insane. The VIX closed the week at 70.33 - that is a record, in case you’re keeping track. But a new all time high record isn’t what makes my eyebrows levitate. It is that the VIX ended higher than on October 10th 2008 - when the market closed lower than on Friday. So while the market is now higher, fear - as measured by the VIX - is actually more pronounced. Interesting.

TED Spread & LIBOR
The credit markets are continuing to thaw with both LIBOR and the TED spread falling. But, and that is a big but, we are no where near normalcy. Both indicators are at extremely elevated levels. They difference is that they are now going in the “right” direction (if you are a bull). But they still have a long ways to go to totally unwind.

Sell Side Indicator
The Sell-Side indicator measures the equity allocation recommendation of the average Wall St. strategist to their clients. As you can imagine, as a group they are a great contrarian indicator just like the newsletter editors (Investor’s Intelligence) or the retail investors (AAII). Here’s a good article which explains it in more detail.

Right now the average allocation is 58% - which is the lowest level in 10 years. However, if you look back more than that, it is clear that we are near levels which would only suggest a cyclical bottom for the stock market, not a secular one (at best):

University of Michigan Sentiment Survey
If we needed another sign that the US consumer is totally pessimistic, the recent Michigan sentiment survey shows an even lower reading than the last time I mentioned it in May (Conditions of a New Bull Market: Consumer Sentiment). At 57.5%, it is now lower than anything we’ve seen in almost 30 years. This is saying a lot when you consider all the shocks that the financial markets have been buffeted with over that time:

The lowest reading in the history of the survey was in May 1980, 51.7%. This most recent result is preliminary and may be changed when it is finalized on October 31st 2008. We actually saw a lower reading than this most recent number in June 2008 with 56.4%. Then things seemed to improve to 70.3% only to fall down again. In any case, these small details matter less than the overall picture showing a shell-shocked consumer.

As you’d imagine, in the upside down world of contrarian sentiment, extremely pessimistic consumer sentiment is bullish.

Hedge Fund Redemptions
Forget mutual fund redemptions, hedge funds, the sophisticated investment vehicles of wealthy individuals and institutions is hemorrhaging assets to the tune of $210 billion. It seems most aren’t absolute return vehicles but closed index funds because in the recent quarter, they produced terrible results for their clients. According to hedge fund watchers, this looks to be the worst year both in terms of asset flows and returns.

Of course, not all hedge funds suffered. Andrew Lahde posted +860& returns and closed shop after just one year.

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

The most recent consumer sentiment numbers from Reuters and the University of Michigan show an extreme pessimism. To be exact, in October, the “current conditions index” dropped to 91.0 while the “expected index” fell to 64.7 — the lowest since Hurricane Katrina.

We haven’t seen numbers like these since 2003 when the bear market gave way to the current bull market. Other than 2003, we’d have to go back 15 years to find a similar consumer sentiment reading.

Now that is extreme. And yet, from a contrarian point of view, comforting. That’s because consumer sentiment is a lagging indicator and by the time extreme pessimism has seeped into the masses, a new horizon shortly appears and the darkness is dispelled. Check out these graphs of the Michigan Consumer Sentiment and you’ll see what I mean.

According to a research study by Meir Statman, a finance professor at Santa Clara University and Kenneth Fisher of Fisher Investments:

Low consumer confidence is followed by high stock returns more often than it is followed by low stock returns.

Although it is extremely difficult to go against the crowd, the best time to buy is when there is “blood on the streets”. With consumer confidence this low the retail sales could be a disaster — although you wouldn’t guess that from the crowds on Black Friday.

The technical indicators (new lows relative to new highs) are aligning and now sentiment is falling into place.

I was unavailable yesterday due to travel. Thanks for the kind messages

Yesterday the market tumbled on sustained selling which according to the pundits was due to the release of low consumer confidence numbers by the Conference Board. It was the largest drop and the lowest reading since September 2005 which was right after hurricane Katrina.

While the market’s decline can’t really be traced to the release of this data point, the correlation does cause some to incorrectly conclude causation. But I suspect the market needed to give something back after a breathless sprint upwards last week.

Last year I mentioned the Michigan Consumer Sentiment Survey and how paradoxically, the low readings seemed to coincide with inflection points in the stock market.

After all, significant bottoms are formed when all seems darkest and hope is for the most part, abandoned.

Mark Hulbert mentions the same in relation to the Conference Board sentiment survey:

The historical record shows there to be a slight tendency for the market to move inversely to consumer confidence, with high returns following periods of low confidence and below-average returns following periods of high confidence. In addition, big monthly drops in the index are more often than not followed by market gains than market losses.

By the way, the Michigan survey dropped to 83.3 in August - its lowest reading in a year. So both surveys are showing significant consumer reaction.

Basically, sentiment surveys provide more insight on what has happened and how the consumer is now responding to previous economic situations (the sub-prime mess for one). They do not really provide any insight into the future, except as a contrarian signal.

I don’t see anything catastrophic to cause me to give up on the bullish correction thesis. In fact, this weak consumer confidence reinforces it. Had the consumer been sanguine, that would have given me a new worry.