Trader’s Narrative

Here is this week’s summary of stock market sentiment happenings:

Sentiment Surveys
Even as the stock market bounced higher, the US retail investors, as measured by the AAII weekly sentiment survey, grew slightly more cautious. This week’s survey showed an increase of bears by 6% points to 44% and a small decrease in bulls to 37%. This is an intriguing turn of events, especially considering that just a short while ago, more than half of this same group of investors was extremely bullish. But just a small pothole on the way to higher stock prices has spooked them to not only grow less bullish very quickly but to also remain so. But there is anecdotal evidence that they are tip-toeing back into the stock market.

In contrast, newsletter editors as measured by ChartCraft’s Investors Intelligence sentiment index continues to be wildly bullish with optimists outnumbering pessimists 2 to 1. This week the bulls diminished slightly to 23.6% and the bulls also shrank a little bit to 48.2%.

And finally, the Hulbert Stock Newsletter Sentiment index shows that the small subset of market timing newsletter editors tracked by the Hulbert Digest have not materially changed their posture. But the Hulbert Nasdaq Newsletter Sentiment index has registered a serious decrease in optimism. This sentiment measure was 57.1% on August 21st, 2009 when the Nasdaq was at 2020. Meanwhile, today the Nasdaq closed almost 61 points higher, but the HNNSI is just 28.6% - almost exactly halved.

We’ve been witness to a schizophrenic sentiment outlook recently. This choppy, one day bullish, the next day bearish, and then back again type of action is usually characteristic of corrections. Such lack of conviction, with everyone ready to switch camps at the drop of a hat makes me think that one side will eventually be caught on the ‘wrong’ side of the market. And their pain will fuel the next leg, either up or down. Honestly, right now I’m not convinced myself which is more likely. I’ll prefer to be in the audience until the fog lifts.

September’s Seasonality
True to form, with everyone’s attention directed towards the dire September seasonality, the market has staged a rocket-ride higher!

Consumer Confidence
The Reuters/Michigan University consumer confidence data released today rose above 70 again. The last time it was in the vicinity of this area was a few months ago in June.

Both the current conditions index and the expectations index rose from August. Either the average US consumer is simply believing the stock market’s message or the US economy is actually getting better.

The consumer confidence survey from Gallup also shows a similar increase (see chart on the left). In fact, the current level is the highest consumer confidence level since they started to track this question at the start of 2008.

Option Traders
Thursday’s one day ISE sentiment (equity only) index was 210 - meaning that there were 210 equity calls purchased by retail clients for every 100 puts. That’s the highest level since July 28th, 2009 when the S&P 500 was at 980 - some 70 points lower. But that’s just a one day super-bullish event so it has little consequence, especially as the ISE index fell hard on Friday (to 137). The short term (10 day) moving average is much more meaningful and it is at 171 which leaves it mired in neutral historical territory.

The CBOE put call ratio (equity only) continues to register very strong bullish sentiment:

The short term moving average is still at a very low level and it is also well under the multi-year channel line. It is certainly possible that this ratio can continue to be mired in this area for some time. The CBOE put call ratio is eve more bullish that it was at the beginning of 2007.

Lighting the Afterburners
This week we saw an incredibly powerful thrust in the markets with pretty much every single issue out there moving up. While this following data point is not technically a sentiment measure, it is definitely a consequence of the return of risk taking on Wall Street: this week saw more than 3 out of every 4 NYSE issue trade higher. This is, needless to say, a rare moment in market history. On the flip side, you’ll recall that earlier in the week Wayne pointed out the incidence of zero new lows in the NYSE.

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

The Present Situation Index of the Consumer Confidence survey from the Conference Board fell to 29.4:

That’s lower than the 2002 bear market bottom. Lower than the confidence level in 1991. Lower than the early 1980’s. Even slightly lower than the darkest days of the 1970’s bear market.

As far as I can tell, the current reading is the lowest that this survey has seen since it was started in the 1960’s!

The Conference Board surveys 5000 US households and their answers to questions about their employment, spending and

From a contrarian perspective this is good news. And this is just another in a long line of extreme pessimism from the average consumer and investor in the US. But from another perspective we need to see at least the start of a change in the doom and gloom before things get better.

If you have a really long term view and don’t particularly care about further declines in the short term, then this is a good signal. But if you want to avoid such potential losses then you have to give up trying to anticipate the market’s exact inflection point and wait for confirmation by giving up some gains to the upside.

Here’s another indicator which dovetails nicely with everything else we’ve seen measuring the sentiment of the US consumer:

Source: Gallop Poll

First of all, who exactly are these people that are satisfied with things now? 7% is 21 million people!

In any case, the last two times that American’s were this unhappy during election time, the results were bad for the incumbent party. Change is a tough proposition for us humans. We much prefer the status quo. But when times are really tough, then we begrudgingly accept the need for change.

I was in Spain (but not in Madrid) when they had their version of 9/11. That tragedy totally changed the outcome of the elections. Before that day the polls were expecting a total crushing defeat for Zapatero but in less than a week it was the opposite.

Getting back to the chart, in 1980 Ronald Reagan defeated Jimmy Carter and in 1992 Bill Clinton defeated George H. Bush. You can already see this reflected in polls which put Obama way ahead of McCain.

Here is the lay of the sentiment land for the week:

Barron’s Institutional Survey
According to the latest Barron’s “Big Money Poll”, the professional investors are fairly bullish but not excited about stocks (see graph). But the majority, 55%, believe the market to be undervalued.

And 87% say they see themselves as buyers within 3-6 months. The remaining 13% see themselves as seller in that time frame.

AAII Sentiment Survey
The American Association of Individual Investors sentiment survey continues to be problematic for bulls. From a contrarian point of view, the ideal is if sentiment remains unchanged or even falls in the face of a market rally. What we are seeing however is the opposite. As the market has recovered, the AAII sentiment survey has shown an alarming increase in bulls.

I mentioned this last week in the sentiment overview and unfortunately, things have gotten slightly worse. Now only 26% of AAII respondents are bearish and 53% are bullish. There is no way we can discount or ignore this. Such a high level of bullishness is downright frightening - from a contrarian point of view. The last time we had this many bulls in the AAII was in October 2007 when the market put in its swing high.

I’ve been also noticing technical indicators also pop up showing a potential for the recovery to stall. So while in the short term we might be in for some turbulence or even a set back, I still think there are enough things in place for a protracted bull market.

Fund Flows

According to AMG Data, for the first 3 months of 2008 equity funds had a net outflow of $29.7 B - including ETFs. Domestic funds had an outflow of $22.5 B.

By March the panic was apparently over and mutual funds and ETFs once again had net inflows: $14.7 B for the month. Net outflows during corrections tells me that the retail investor isn’t stubbornly clinging to hope. But selling in fear that things will get worse. But in the end, the market needs inflows to be able to power ahead.

When you combine the healthy return of inflows to mutual funds and ETFs with the limited supply of securities due to a lack of IPOs, and secondaries as well as the further restriction of supply through continuous buy-back programs, you have the right setting for a powerful bull market.

Warren Buffett: “worst is over”
The Sage of Omaha believes that “the worst of the crisis in Wall Street is over”. In an interview he said that he supported the Bear Stearns buyout because there was a real risk of contagion had it fallen. He also thinks “the Fed did the right thing” by stepping in and acting as a direct lender to the financial companies in need. Of course, this is little consolation to those who are being squeezed by the mortgage crisis but from a trading or investment point of view, it is nice to have someone like Buffett confirm that Armageddon was averted. At the same time, Buffet - unlike Richard Russell - is not a raging bull. He thinks that we will see moderate future growth, much less than in the past decades.

PVA Valuation
This isn’t really sentiment, as such, but I include it because it dovetailed nicely with Barron’s poll results where most respondents believe the stock market to be undervalued.

Ford Equity Research uses a proprietary measure to determine valuation for a company. They take the market price of the company’s stock and divide by value, derived from “a proprietary intrinsic value model”. According to Ford, 40% of the almost 1,800 US stocks it tracks are undervalued.

This, by itself, wouldn’t mean much except that this measure has an enviable track record. The previous times that it showed a higher percentage of stocks undervalued was at the end of 2002, as the bear market ended, with 48% of the stock universe undervalued. The second instance when there were more than 40% of stocks undervalued was in 1998, during the Asian financial crisis (also known as the LTCM debacle).