Trader’s Narrative

Let’s take a quick look-see at the sentiment for this past week:

ISEE Sentiment Index has backed off the low extremes considerably and hit 125 - so retail option traders are buying slightly more calls than puts. This is to be expected and unless we see this indicator reaching +200 the rally shouldn’t be in danger.

Short interest ratio is the number of shares of stock sold short compared to the average daily volume. On the NYSE, this ratio is close to 9. By itself this would be astonishing because it is the highest ratio in history. But there is more going on than simply rampant shorting of stocks. A new structured fund product has taken off on Wall Street, sucking in billions of dollars to a long/short strategy.

The AAII sentiment has ameliorated slightly with just 49% of retail investors feeling bearish this week. But still only 30% are bullish, leaving us with quite a bit of left over panic.

LowRisk’s 30 day outlook continues to be mired in absolute dejection: 59% bearish and 36% bullish. The remarkable thing is not only the degree of bearishness but that there are so few fence sitters (only 5% are neutral).

The troublesome Investor’s Intelligence sentiment continues to back off its bearish signal of the last few weeks. This week bulls are only 40% - a level we reach at intermediate market bottoms. The past few times we got this low were: summer 2004, summer 2006 and August 2007. Having said that, we still are not seeing any sort of panic in newsletter-land.

The Hulbert Stock Newsletter Sentiment index is mirroring the II picture with only an average of +10.1% exposure recommended by stock market timing newsletters. Seeing how the historical maximum is +79.7% and the minimum is -81.8%, things are decidedly lukewarm. But Mark Hulbert, keeper of the HSNSI interprets the concomitant rise in bullish sentiment with market prices to mean that the rally is hollow and bound to retest the recent lows.

Recent Yahoo! (YHOO) holders are all too familiar with a retest of lows. That is, before this morning’s surprise announcement from Microsoft (MSFT) regarding their amorous intentions. If you were holding YHOO, I hope you took at least some money off the table.

UPDATE: Its been a while since I mentioned the TickerSense blogger sentiment poll but I just noticed that the bulls are at only 24% while the bears are at 44%. This is the highest disparity between the two camps since March 12th, 2007 when bloggers were 13.16% bullish and 42.11% bearish.

I’m a bit wary of giving this too much weight because of the edgeless nature of this particular sentiment indicator. But if you notice, there’s been a remarkable switch since last August: bulls have been more predominant than bears. So now, after months and months, we see the bulls finally capitulating. There may be something in that pattern.

A bull market climbs a wall of worry. Or so goes the Wall Street maxim. The market has a love/hate relationship with bears (and they with the market) but it needs bears fervently. A bull market feeds on bears and their panic, fear, caution and disbelief.

A great way to quantify the bears and their activity (as opposed to just their sentiment) is to track short interest positions. This data is released by the NYSE and Nasdaq exchanges on regular intervals. And although like the commitment of traders, it is somewhat dated data, it is still very useful.

But it can get tricky because we can’t really start comparing today’s data to say 5 years ago. If you look at a chart of short interest you notice that it just keeps going up and up (the opposite of cumulative breadth). That’s because the market, trading volumes, number of listed securities, etc. have all increased. So somehow we have to convert a series into an oscillator to extract meaningful data. There are a few methods but the most simplest is to track the data series relative to a moving average of itself. Another is to compare it to the daily average volume in the market. This is called short interest ratio.

Right now both Nasdaq and NYSE short interest ratios are at levels which show a remarkable disbelief in the bull market. Last month saw a 9% increase in Nasdaq short interest and the last 5 months a 33% rise. The NYSE short interest ratio is a bit more extreme than Nasdaq’s in fact. So as the market has continued to rise, more and more people are betting that it will fall.

All these short positions puts a floor beneath the market. If the market begins to fall, shorts will cover to profit (buy). A large short position can also be the fuel for momentum. If the market continues to rise, shorts will cover (buy) as their stop losses are hit.

Another measure is to look at odd lot purchases and odd lot short sales. These are transactions made with less than 100 shares, therefore they must have been made by small traders or investor. NYSE odd lot purchases and NYSE odd lot short sales are both in neutral territory relative to their historical extremes. The public doesn’t have very much conviction one way or the other right now.

As long as these two measures do not reach their extremes (for short sales, low levels and for odd lot purchases, high levels) we’re in the clear and the market can continue to climb. But sustained readings at those extreme levels would be bearish because the public would then have come to fully believe in the rally and throw caution to the wind.

But picture isn’t quite so uniform in its bullishness. NYSE public short ratio which measures only public traders/investors as opposed to specialists and member firms activities is a tad high. This is confusing because it doesn’t confirm the odd lot shorts measure. Who said this was easy? Perhaps this is because while the short interest data moves slower in an easily definable trend, the public short ratio and the odd lot measures are much more erratic and volatile. So we may very well see them quickly come into alignment with the short interest data.