Trader’s Narrative

The Dow Jones was in fine summer condition putting in the best July performance since 1989 and its best month since 2002. Are we in thin air territory yet? To find out, check out the sentiment summary for this past week:

AAII
After 6 weeks of the bears continuously trouncing the bulls in the AAII weekly sentiment poll - something we hadn’t seen since the low in March earlier this year! - the bulls are back. The most recent survey of retail investors shows that optimists rose 10% points to reach 48% and the bears fell 11% points to just 31%.

We need the retail investor to return to the stock market for there to be a real and prolonged recovery. But such a jump in sentiment is troubling. Previously it has not supported higher prices going forward.

Investors Intelligence
The percentage of bulls jumped to 42.4% and the bears decline to 31.1%. So we continue to see a healthy amount of optimism from the average stock newsletter editor, although not excessively so. And this week’s numbers take us back to where Investors Intelligence sentiment was at the beginning of this month - when the S&P 500 was trading some 110 points lower.

Money Market Cash Levels
Believe it or not, there is more than $3 trillion sloshing around in money market funds. But the nominal amount of funds isn’t really that helpful to us since just like GDP it continues to grow along with the economy. What is helpful in determining where we are in the big scheme of things is the movement between equity markets and money markets.

Obviously when investors are fearful, they sell anything and everything ‘risky’ and put their money in the protective but less lucrative vehicle of money market funds. That’s exactly what we saw in March of this year: Tsunami Of Cash Just Waiting To Be Invested. Unbelievably, the total assets of money market funds was higher than equity funds!

That has now returned to its normal historic ratio with total money market funds decreasing to just $3 trillion. But it isn’t only the return to the historical pattern that is noteworthy. What we’re seeing is not an orderly and mild shower of liquidity but a veritable tsunami as both retail and institutional investors move massive amounts of assets from cash. Not only are they moving record shattering amounts, they are doing so in just one month’s time. So whether this recent rally is the real thing or not, large and small players are reacting to it with the reflexes of a cobra.

While this may be interpreted as very bearish, you have to note that not every single dollar taken out of money market funds is automatically put in the equity market. In fact, only a small portion is destined there. Had every single dollar been invested in the stock market by the way, we would probably bee looking at the S&P 500 at least 30% higher from where it is. The rational take away from this measure then is that the participants in the financial markets are recovering from the shell shock they suffered earlier this year and late last year.

Option Traders
Yesterday when we briefly broke above 990 on the S&P 500 index, the CBOE put call ratio (equity only) hit 0.50 - that magically half point marker is significant because it shows the average option trader’s raucous disregard for risk as they reach for the long side. Historically, it takes the market a few days to digest this before reacting lower. However, the last time the put call ratio plumbed these depths was in mid-April, earlier this year. And it was totally ignored by the market on its merry way higher.

On Wednesday (July 27th 2009) the ISE sentiment index (equity only) reached 220. That’s the highest level since June 15, just before it started a protracted decline from the June swing highs. As well, we’ve seen several days of higher ISEE data so the 10 day moving average that I track has inched higher as well. The last time the short term moving average was around 170 was in early June, just as the market ran out of steam.

Rydex Market Timers
Traders in the Rydex family of mutual funds have once again reached for the stars. These are fast, market timers who switch between the Nova/Ursa (bull/bear) funds to make money on either side of the market. As a group, they are a good contrarian indicator when they reach an extreme. As they have now.

The last time they caused us to mind their positions was back in mid June 2009 when they had a herded into a bullishly lopsided extreme.

Insiders Selling
Corporate insiders are once again selling their own company’s shares at a pace that is alarming. According to Vickers Weekly Insider Report, more than 4 shares are being sold now for every 1 share bought by an insider. To find a higher ratio we need to go back to October 2007. While this may appear to be a bright, red blinking light, there’s more reason to treat it as a cautionary yellow.

That’s because insiders, for all their reputation, do not have such a great track record in timing their own shares. They obviously do have an edge on others but they aren’t perfect and certainly can be wrong. But more often than not, they are right but tend to act too early - by about a year.

Here is this week’s sentiment wrap-up:

Hulbert Newsletter Sentiment
One of the most important aspects of sentiment analysis is that it presents us with a snapshot into the mindset of the general investor at a pivotal moment - like a retest of a bottom. As the S&P 500 heads down towards its November lows once again, the sentiment picture doesn’t bode well for the bulls.

To see why, let’s go back to the last bear market low in 2002-2003. At that time the Hulbert Stock Newsletter Sentiment Index (HSNSI) hit +10% at the low in October 2002. This meant that the average market timing newsletter was suggesting a market exposure long of 10% of a client’s portfolio.

When the S&P 500 (SPX) melted back towards the 800 range the vast majority of people had given up on the market and instead of going long were suggesting shorting the market. That was a demonstrable show of capitulation on the part of die hard bulls and it was one of the reasons that we lifted off to a new bull market:

Now compare that to what we are seeing now. Since the low of 750 for the S&P 500 Index (SPX) the average market timing newsletter as measured by the HSNSI is actually more bullish!

Of course, this not only flashes a bright red caution light for the bulls, it dovetails nicely with all the other sentiment data we’ve been looking at recently.

Sentiment Surveys
According to the ChartCraft Investor’s Intelligence survey, the bulls increased slightly to 43% while the bears remained the same.

In contrast, the AAII sentiment survey showed a large drop in bullishness - from 48.70% to 27.63%. The bearish reading increased but not as much - from 35.06% to 47.37%.

ISEE Sentiment
There was no significant change to report with the ISE sentiment index.

General Sentiment Measures
I’ve outlined a few lesser known measures of general sentiment which are hitting very low or all time lows. If you missed them, they are the Conference Board Consumer Confidence and the State Street Investor Confidence Index.

Market Breadth
The percentage of S&P 500 stocks above their 10-day moving average is once again below 10%. This is usually a rare event but thanks to the tumultuous market of 2008 we have gotten used to seeing this more and more. Within a bull market this is usually a very good indicator of a significant bottom but in this market I wonder if it has the same significance.

Volatility
The CBOE volatility index has regained the 50 level once again (peaking at 55) but there it has met the declining 50 day moving average and the previous technical support line. My hunch is that this is a reaction to the rapid decline and volatility will continue to fall.

Is it just me or is this tape incredibly frustrating? We’re dripping lower, seemingly on our way to test the January lows. But it is anyone’s guess if we we’ll get a head fake lower and then reverse up or just cascade down into a continuous bear market decline, ala the 1970’s.

To help light the way, here is the sentiment overview for the past week:

Hulbert Newsletter Sentiment
According to Mark Hulbert, the keeper of the HSNSI (Hulbert Stock Newsletter Sentiment Index), there is contrarian arguments that the January low will be intact.

This week’s market decline brought down the portfolio allocation of stock newsletters to -16.4%. That means the average market timing newsletter iss advising their clients to be short the market.

The HSNSI is now not only below the January 22nd lows, it is the lowest such sentiment reading since October 2005 when it scraped -30%. The silver lining in the clouds is that newsletters are dejected and starting to throw in the towel. They are not stubborn in their denial of a declining market. That, according to contrarian analysis, sets the stage for a potential rally.

Option Market
As I pointed out yesterday, the CBOE’s equity only put call ratio spiked to a four year high. Today it retreated to 0.90 - still quite high but backing away from everest proportions.

On Friday it was the ISEE Sentiment Index’s day to turn heads. I suppose the retail traders read the headlines and watched the TV reports from Thursday’s trading, got freaked out of their minds and started buying puts hand over fist, pulling the ISE sentiment index fdown to 65 - the lowest it has been since January 17th of this year.

On that day the ISE index was 60, meaning that retail traders were only buying 60 calls for each 100 puts. Strangely enough, the market bottomed a few days later (January 22nd or 23rd, depending on whether you go by the intra-day low or the close) when the ISE ratio was much higher: 105 and 98!

This is exactly what happened during the March 2007 retest of the bottom. During the first decline, the ISE sentiment dipped to the 60’s but during the subsequent retest, it was at par (100).

AAII Sentiment Survey
Finally, among the sentiment surveys this week, the AAII results stand out with a meager 22% bullish and 50% bearish (again). During the January decline, the AAII survey showed similarly low bullishness but the rally it ignited was mild to say the least. You remember this chart, right?

We’ll have to wait a few more weeks to see if it will be borne out but it is an understatement that so far, it has been a disappointment. By the end of this month, we’ll have given it the 13 weeks it requires. Let’s see if the AAII contrarian sentiment analysis lives up to its history - mark your calendars!

Investor’s Intelligence
In agreement with the retail investors, this week’s Investor’s Intelligence sentiment survey shows the newsletters at 42% bullish and 37% bearish. Both those levels correspond to extremes, which can be interpreted according to contrarian thinking as very bullish for the market.

To wrap up, while we may have to endure some further turbulence due to our proximity to the January lows, the sentiment is horrible out there and it will set the stage for an intermediate to long term rally. The trick will be to not get shaken out of long positions while still maintaining discipline.

According to the Hulbert Financial Digest, stock timing newsletter editors en masse abandoned the market as the October highs melted into November losses.

Back in October, as the market was making a swing high, newsletters recommended an average exposure of +50% - that is, an allocation of 50% of a portfolio to the long side.

Last week, as both November and the market swoon ended, the editors had jumped ship and were actually suggesting an exposure of -13% - an allocation of 13% of a portfolio to the short side.

Although this is not the most extreme short allocation and sentiment has recovered somewhat since then, the way that they jumped so fast from a bullish stance to a bearish one, is telling from a contrarian point of view.

Had the decline been met with disbelief, or worse, an increase in bullishness, then I would be really worried. But sentiment agrees with the other technical data and we are already seeing a recovery, as I thought we would.