Trader’s Narrative

Here is the wrap up of this week’s sentiment data:

Sentiment Surveys
The weekly American Association of Individual Investors (AAII) stock sentiment survey shows a surprising increase in optimism. Of the respondents, 44% were bullish (a 5% increase from last week) and 35% were bearish (a 10% point drop from before). We aren’t near any sort of extreme level, however the direction of sentiment is puzzling since the stock market closed lower than it has for the past 18 days.

Investors Intelligence
The stock newsletter editors, as measured by ChartCraft’s Investors Intelligence, shows a similar increase in optimism. This week the II had 50.6% bulls (4% point increase from last week) and 23.6% bears (a 0.8% decrease). I’m not sure how helpful this is as the Investors Intelligence bull/bear ratio has been relentlessly hovering around 2:1 for the past few months.

In contrast to both of the above sentiment surveys, the Hulbert Stock Newsletter Sentiment index which measures a sub-set of market timing newsletters is showing a decline in bullishness. The HSNSI was at 45.2% when we hit an intra-day high of 1080 on the S&P 500 index. But now it stands at less than 29.1% a significant sentiment erosion in response to a small retreat in the index.

A recent survey of institutional investors by TheMarkets shows that an increasing number of them believe we have seen a definitive low. While in June 40% thought so, now 70% do. Furthermore, 90% of them expect the S&P 500 to climb to the 1200 level by the end of the year in 2011. Back in March only 50% were as optimistic about the S&P 500 reaching that goal.

Fund Flows
An estimated $29 billion was withdrawn from equity mutual funds (domestic) by US retail investors for the month of September. Meanwhile, they dove head first into fixed income funds by buying almost $46 billion worth of taxable and municipal bonds last month. This is a continuation of the trend which I highlighted before: Equity Mutual Funds Show Outflow Even After 60% Stock Market Rallly.

So if it isn’t Mom’n'Pop investors and it isn’t corporate insiders, who is buying? Leaving aside conspiracy theories of the Plunge Protection Team - because let’s face it, if they exist they are very bad at their job - we are left with opportunistic hedge funds. The usual suspects are either grey/black boxes or discretionary traders chasing a momentum market higher. Remove this remaining leg and the table get mighty wobbly.

Option Traders
The short term moving average for the ISEE sentiment index (equity only) fell slightly from last week’s high of 196. As you can see from the chart, these were gidy levels which we hadn’t seen since late 2007, just before the bear market began:

Zooming in on the week’s data, the ISE sentiment index hit a high of 204 on Tuesday but as the S&P 500 fell for the rest of the week, it actually registered a slightly more optimistic tone. I was watching to see if we would make it down to 100. But this small decline was not enough to rattle anyone in the ISE.

The CBOE put call ratio (equity only) reacted slighly more in response to the weakness in equities:

In contrast to the stubborn complacency shown in the ISE option data, the CBOE (equity only) put call ratio jumped to 0.84 on Friday - getting really close to the noteworthy 1 level. As well, the ratio increased every single day of the week, even on Monday when the S&P 500 closed higher.

Grey Beards
Checking in this week with a market guru who both literally and figuratively has earned the title of a ‘Grey Beard’. Steve Leuthold, the 71 year old money manager who is not afraid of going short, is very bullish right now.

Leuthold expects the S&P 500 to end the year at 1200 and even higher at 1350 next year. In keeping with that bullish view, he has 72 percent of his fund invested in equities.

“There’s pretty good momentum, and the market psychology is right. The markets turned up before the economy did. Now, the economy is improving. It might be a little better than most think. It ain’t wonderful, but it’s a lot better than it was.”

Meanwhile, Doug Kass and David Rosenberg as well as Bob Janjuah of RBS - all of whom I’ve mentioned before - remain decidedly bearish and unmoved.

The Coppock Guide. Just a while ago no one knew it even existed. I’m willing to bet even if you mentioned it in a room full of TA buffs, you would get quizzical looks all around.

But now suddenly it is the belle of the ball! Everyone is talking about it. There is a buzz in the blogs, Bloomberg, MarketWatch (WSJ) have stories on it and even CNBC’s Fast Money, which normally has the attention span of a fruit fly gives it a mention (see below for video). To be honest this is exactly what I was afraid of when I first hesitatingly brought it to your attention in Conditions of a Bull Market. I’d rather it remain the esoteric indicator it used to be (hopefully everyone will forget all about it).

The question remains: is it useful?

I tend to think so but some disagree.

Mark Hulbert looks back all the way to 1896 and calculates the success of Coppock Guide signals on the Dow (see article). His conclusion is that the returns are not indicative of an edge.

However, what Hulbert doesn’t point out is that although the Coppock Guide for the Dow Jones Industrial may be a poor indicator, that doesn’t mean that it is for other, more respectable indexes like the S&P 500. What Hulbert does point out in a subsequent article is that even for the Dow Coppock numbers, the two false signals in the 1930’s skew the results and if we look at more recent data, the indicator does have an edge. So the question is how relevant is the 1930’s to the current market?

Guy’s analysis at the Technial Take also falls into the same trap as Hulbert by looking at the Dow Jones Industrial. I don’t want to rehash why the Dow is inferior to the S&P 500 (price weighted vs. capitalization weighing and small sample size of 30 vs. 500). The only time I give the Dow more respect is in the Dow Theory analysis of the market.

On the other side, there are those that see the Coppock Curve as a valuable guide:

James Stack of InvesTech is one of them. Formerly an engineer by training (who worked for IBM) Stack’s whole approach is a blend of quantifiable edges (whether technical or fundamental) and sentiment analysis. But he doesn’t rely on the Coppock exclusively.

Another is Steve Leuthold of Leuthold Weeden Capital Management. He calculates a similar indicator that he calls the VLT Momentum (”very long term”). I consider Leuthold as one of the ‘grey beards’ who get my respect for their successful navigation of the market over decades. Recently Leuthold has turned even more bullish (after nailing the March low).

Next is Jason Goepfert of SentimenTrader. Recently Jason did a complete analysis of the Coppock signals (using the S&P 500) and showed that it has a definitive edge, especially on a risk adjusted basis. To see the data get a 14 day free trial and take a look.

In the end, the headline is rhetorical because I’m not really going to defend this or any other indicator.

First of all, it is just that, an indicator, with all the inherent flaws and limitations. I don’t expect anyone to exclusively trade off it. In fact I think that would be nuts.

Second, one has to just look at the data. How you want to take advantage of the Coppock Curve, if at all, is really up to you. Above you’ll find enough information to make up your own mind. But treat it as a starting place and do your own research. Then drop me a note - whether positive or negative.

Finally, the Coppock Curve is just one of the conditions for a new bull market - I’ll cover the others soon. I pay much more attention to the weight of indicators, rather than just any one in particular, no matter how impressive its historical performance may be.

Here’s an incredibly shallow analysis of the Coppock Guide (what else did you expect from CNBC?):

Here’s this week’s walk through the sentimental landscape:

AAII
The retail investors, as measured by the weekly AAII survey are paring their new found bullishness. The bulls are down to 34% while the bears increased to 45% (each going in the opposite direction by 10% points from last week). Although this is an about face, it only takes us to sentiment territories we have occupied since late March.

Investors Intelligence
The newsletter editors on the other hand as sticking to their guns. According to ChartCraft, this week the II bulls are at 40.7% - almost unchanged from last week - while the bears were 29.1% - down slightly from last week.

ISEE Sentiment
Although we closed the week down, and Friday flat, the retail options traders, as measured by the ISE sentiment, were quiet ebullient. They spent the entire week see-sawing up and down then on Friday they bought twice as many calls as puts, putting the ISE sentiment index at an even 200 (equity only).

To get some perspective on this, see last week’s sentiment overview which showed a chart of the ISE index and a short term moving average. All in all, such optimism has easily tripped up the market in the past.

CBOE Put Call Ratio
We see the same nonchalant display from the option traders at the CBOE. The put call ratio (equity only) continues to drip lower, reaching for the uptrending channel that it has occupied for some time:

The 21 day simple moving average has been a good guide for timing the market with this indicator. Whenever it has fallen to similar depths, the market has had either a tough time or fallen precipitously. But, as you’ll notice, the CBOE put call ratio has been behaving rather bizarrely throughout this bear market.

The S&P 500 has managed to sustain an uptrend even as the put call ratio has fallen to levels which previously would have halted it in its tracks. Arguably, the market should have stopped going up sometime in April. Of course I mean that facetiously because I’m not about to tell the market what it should or should not do.

The Grey Beards
I keep track of a few ‘grey beards’ - investors who have lived through several bear and bull markets and have the scars to prove it. The 71 year old Steve Leuthold of Leuthold Weeden is one of them. He called the March bottom almost to the day! Click to watch the Bloomberg video here (from March 4th 2009).

Keep in mind that he runs a short fund aptly named Grizzley Short Fund. But he’s agnostic enough (and brilliant enought) to see opportunity when it presents itself. Since having changed his position, he now is considering adding to his longs - for details see this article (and video) from Bloomberg that I already showed you at news.tradersnarrative.com

How’s this as a strange contrarian indicator for the Chinese stock market? This is a billboard advertisement for Yinji Shopping Mall in Zhengzhou featuring a hanging mannequin next to a graph of the stock market:

The agency behind the billboard explain that they are making fun of the Chinese stock market. In Chinese, the billboard reads:

It’s better to invest money here than put it into the stock market.

What I’d like to ask the agency is why do they have the graph going up if they are making fun of the market’s fall?

The Shanghai Composite has fallen 72% from its high on October 16th, 2007. Compare that with 45% for the S&P 500 Index (from its high on October 2007 to the low in October).

This mention of Chinese stocks in the most recent edition of Barron’s caught my attention:

We have 10% of our equity holdings in companies outside the U.S. We have a huge database covering 59 countries and every stock with a market cap of more than $200 million. One of the countries that looks really interesting is China. There are still 214 Chinese companies that have more than $1 billion in market value. The mean P/E on those stocks, as of last week, was 13, down from a peak in 2007 of about 56 times.
In China, you are going to see slower gross-domestic-product growth of maybe 5% or 6%, down from 9%, but there are some extremely attractive values there. And although people say you are trying to catch a falling knife, the Shanghai index is down 75% from the peak in October of last year. So China has become our largest holding in terms of emerging markets.
Steve Leuthold

Leuthold is one of the “greybeards” - market players who have seen and know a lot. So you’ve got to respect his views, even if you don’t defer to them.

Way back in May 2007, much too “early”, I began to suspect the Chinese equity markets were in a speculative bubble. When the Chinese government increased the stamp duty, for all intents and purposes, it was the death knell for the Chinese stock market. It took a few months and prices went parabolic in those final months - as they always do just prior to an implosion.

Previous bear markets:
Measured by the Shanghai Composite, here is a list of previous declines from the year the market topped to how much it fell:

1992 — 72%
1993 — 77%
1994 — 49%
2001 — 55%
2008 — 72% (so far)

Here are a few ways to get Chinese exposure:

• Morgan Stanley’s China A-Share Fund (CAF)
• Taiwan Greater China Fund (TFC)
• The Greater China Fund Inc. (GCH)
• China Fund Inc. (CHN)
• JF China Region Fund Inc. (JFC)
• SPDR S&P China ETF (GXC)
• iShares FTSE/Xinhua China 25 Index (FXI) — Edit: thanks Greg

All except the last are closed-end funds, so they may not trade at their NAV. Also, CAF is the only way I know that outsiders can get in on the A-Share’s market.

Before we say goodbye to not just a bad October but the worst month since the 1987, here is a quick roundup of the sentiment landscape:

Sentiment Surveys
According to ChartCraft, the Investor’s Intelligence sentiment survey shows newsletter editors little changed in their outlook this past week: 23.1% bullish and 52.7% bearish. That is still an extremely high level of pessimism for a normally cheerful bunch. Remember, doom and gloom doesn’t bring in the subscription coin.

The retail investors on the other hand continue to be nonchalant. The AAII weekly sentiment survey showed a small uptick in bearishness to 40.6% and a small downtick in bullishness to 37% but still the over all mood is way too cheerful for me. As a contrarian I’d be much more comfortable to see the average person continuing to be pessimistic about the market before getting too excited about a lasting rally.

Options Market
Like many, I continue to wrestle with the options market, trying to make some sense out of the data it generates. For more, check out not only my own thoughts about this crazy options market but some of the most respected technical analysts out there today.

The ISEE sentiment continues to be ambivalent about this whole chapter in the stock market. I have no idea why but it has totally broken down and although I continue to watch it, it is tough to ascribe a rationale for its moves or to glean a message from it.

The CBOE put call ratio (equity only) went up on Thursday and Friday implying that options traders on average were not totally buying the most recent rally.

Short Covering or Real Buying?
The reluctance to see Tuesday’s rally as “real” is shared by many. After all, the majority of the biggest one day gains in the stock market have occurred during brutal bear markets. A reader contacted me wondering if it was “just short covering” or “real”? I’m not sure if it makes much of a difference. The short interest ratio for the Nasdaq is very high, which is traditionally a bearish omen. Any other ideas on how to distinguish between a “real” rally and a short covering one?

Lowry’s 90/90 Day
The market continues to make people stare at their screen like goldfish, widemouthed and blinking in amazement. Tuesday’s rocket ride sure felt like a 90-90 up day, which according to Lowry’s research is a prerequisite for a new bull market. We’ve seen repeated 90-90 down days but finally got a decisive buying stampede. Up volume demolished down volume by a ratio of 19:1 - the most exaggerated ratio since last year.

If you still haven’t, read Paul Desmond’s seminal work in my free trading resource section (Reports & Articles)

Consumer Confidence
This should be an interesting holiday season for the retailers. The American consumer is not only incredibly dissatisfied with everything in general, they are extremely pessimistic about the future. Like so many other indicators we’ve been watching during this bear market, the Conference Board Consumer Confidence (Expectations) plunged to its lowest level ever.

That is lower than the aftermath of the 1987 crash, the bear market in the 1970’s and the public’s reaction to the tragedy of 9/11. Which says a lot. Consumers are basically shell shocked. The spending orgy, fueled by easy credit, is gone. Now comes the hangover.

From a short term perspective this may appear to be bad news but historically troughs in consumer sentiment have been a great contrarian indicator. After I mentioned it as a condition of a new bull market, it rebounded briefly but the message is unmistakable.

Greybeards
In the past few weeks we’ve seen Warren Buffett, Doug Kass and Steve Leuthold all saying pretty much the same thing: they are buyers. Which leaves one wondering. If you are going to fade these guys, you better be incredibly lucky and incredibly smart. It is possible they are wrong - but highly, improbable.