Trader’s Narrative

At the start of the week we contrasted the strange pessimism that has gripped the US retail investor to the levitation act of Wall Street. It is almost as if Wall Street threw a party and other than institutional investors, a few day traders and algo quant jocks jamming high frequency trades, no one else showed up. If you ask Paul Desmond, of Lowry Research, this is a real bull market that will last another 3 years.

With all due respect to Desmond, today I wanted to entertain some bearish counter arguments to temper that cheery outlook and delve a little deeper into the market condition both in the short and longer term.

While considering the same ICI fund flow data, it is conceivable to come to bearish conclusions. Take for instance the fact that domestic equity funds have attracted less than $8 billion of fresh capital since the lows in March. Had this rally provoked the same pattern of retail investor participation as previous ones, we should have seen $150 billion flow to equity mutual funds, according to TrimTabs.

Maxims ad Nauseum
While it has become an accepted maxim repeated ad nauseum that a bull market likes to climb a “wall of worry”, the historical evidence is otherwise. The stock market actually tends to float higher on gradually increasing levels of optimism - until that optimism reaches a crescendo and then the whole thing unwinds. And we start all over again. So generally speaking, the stock market performs better following periods where there are net inflows of funds.

Whether retail investors are acting intelligently by avoiding this rally or more accurately, by selling this rally, is something that only history can answer. It isn’t hard to imagine though, the possibility that they are reacting emotionally. Think of it. Having first experienced severe loss in their portfolios and watching Wall St. insiders ride on a cushion of bonuses, insult is added to injury when they have to fend for themselves in a new harsh economy.

What if we are seeing the rejection of the great “equity culture” and the almost religious belief in “buy and hold”? What if the record inflows to bond funds are being driven by a traumatized populace seeking the one shelter of income investing?

So far, this has been so relentless that it has pushed the fixed income share of US household wealth above 6% once again. But if you notice, the last time there was a similar increase happened during one of the strongest bull markets in equities:

However, what is undeniable is that if the US retail investor doesn’t return to equities eventually, what we could see is another lost decade; where markets flop around like a dead fish, but don’t really go anywhere. This is what happened before the great super-bull market was launched in 1982.

The completely stark scenario is one where retail investors continue to ratchet up their sales of equities and push the stock market lower as a cascade effect takes place where gloomy sentiment and fear feeds on itself. Think of it as the great unwinding; or the negative wealth effect.

Technical Weakness
Returning to more present and short term matters, the market came perilously close to the invisible 20% distance from its long term moving average. Yesterday I mentioned that stocks have little room to the upside and while I’m not surprised to see the weakness today, it by no means guarantees that we won’t see a final push to 1120.

On Monday 94% of the S&P 500 stocks closed above their 10 day moving average. That’s the highest since mid July. Since then this measure of breadth has backed off slightly but is still hovering above 90%. Other negative technical considerations are that prices are pressing against the downtrend line at 1100 - from the top of the bear market (in October 2007). And that other major market indexes like the Nasdaq, Russell 2000, the Philadelphia Banking Index (BKX) and the Semiconductors (SOX) are still below their previous swing highs. Finally, volume continues to be anemic as it has been for most of this whole trip.

A quick summary of all things sentiment-wise for the stock market this past week:

Sentiment Surveys
The mind set of the retail investors as measured by the weekly AAII sentiment survey shows little change. We had an increase of 7% points for the bearish camp to 46% and a decline of 6% points for the bulls to 33%. Which is not very helpful as it leaves us mired in “no man’s land” - exactly where we’ve been for the past few months.

In contrast, the Investors Intelligence weekly survey of newsletter editors continues to be dominated by optimism. This week we had a small reduction in the bullish camp to 44.8% and a small increase in the bearish camp to 26.4%.

Bond Bears
For what is happening in terms of sentiment in bonds, check out the post from a few days ago: bond sentiment.

Options Sentiment
CBOE put call equity ratio: We got a slight ‘blip’ on Thursday (June 17th 2009) when this ratio hit 0.88. That’s not even close to a level which would get any contrarian excited. But it is the highest level of fear shown in this indicator since early March 2009. Keep in mind though that this trusty indicator has been firing blanks throughout this bear market.

ISEE Sentiment index: the equity only call put option ratio from the ISE reached a low this week we haven’t seen since November 2008. Remember, this is inverse to the usual put call ratio so a large number denotes optimism and a low number fear. On Thursday the ISEE Sentiment index reached 92 (meaning 92 calls purchased for every 100 puts purchased to open a retail options position).

This dovetails with the technical indicators that are also showing a very short term oversold condition in the market. The key is how the market reacts as a result: will it use it to bounce strongly higher? or collapse lower in spite of it?

Secondary Market
The doors of the IPO market have been shut tight for many months now. And although we are seeing the door budge open again slightly, the real action has been in the secondary market.

According to TrimTabs, last month saw a record shattering $64 billion dollars of IPO and secondary market offerings combined. To put that in perspective the previous monthly record was just $38 billion. While TrimTabs didn’t provide a sector breakdown, I suspect that most if not the vast majority of the record issuance was in the financial sector.

Historically, there is an inverse relationship between the primary and secondary market activity and forward market performance. This isn’t surprising since at the heart of the market, once you remove all the noise, is a simple supply and demand equation. There are a finite number of dollars chasing a finite number of shares. If you tip the balance in one direction, the market will react eventually.

According to two methods of analysis (from TrimTabs and Ned Davis Research) we are seeing a historical extreme that has only been seen before quite rarely. For more details, check out this article by Mark Hulbert. My only criticism of this analysis is that they use nominal numbers instead of ratios.

Since the market generally rises over time (recent history excluded), it isn’t helpful to compare the secondary market in say 1998 in dollar terms to that of today. The way we can equalize it is to look at the ratio of the secondary market to the total market (for example, the total equity value of the S&P 500). In this way we can easily compare across decades and get a more accurate idea.

This criticism notwithstanding, since the other extreme readings come from relatively recent years (2000, 2008, etc.) we can conclude that a ratio analysis would yield little improvement. The conclusion stands that Wall Street is suddenly awash in ‘paper’. I’m sure some will come up with conspiracy theories of this spring rally being rigged to allow for the recapitalization of the ailing US banks. But remember what Ben Graham said about the stock market: “In the short run it’s a voting machine, but in the long run it’s a weighing machine.”

Eventhough I still think of this as another bull market correction, I bemoaned the lack of real fear in the market. Now, this final puzzle piece seems to be falling into place.

Panic T-Bill Rush
Among the strongest signs of real fear in the market is the mad dash to the safe harbour of risk free short term treasury bills. This past Monday we saw a dislocation in the fixed income market that is seldom seen. But whenever it does rear its ugly head, it is a sign of better times ahead.

This kind of fear and loathing doesn’t register on the usual sentiment indicators that most people watch. But as a reflection of a market that is now mostly made up of institutional asset managers and other large players, it is a very important tell.

AAII
This is the most stubborn sentiment survey, in that it hasn’t really registered a panic or shown any real fear. The AAII bears only number 43%, down from 46%. Usually the retail investor gets so spooked that the percentage of bears spikes beyond 50% - as it did in early March of this year.

However, my working theory is that since the retail investor has been pulling money out of the market at record rates, they are simply not a meaningful participant in the market. According to estimates from TrimTabs, they are sitting in bonds and money market funds (see video). So if they do not have anything substantial at stake in the stock market, why would they get bearish and panicky?

Market Vane
After a small hiccup, this sentiment survey fell to 52% which is the lowest it has been since late 2003. From a contrarian point of view, this is bullish because even as the market has recovered, there are now even more bears. It would seem that the majority of the CTA’s that Market Vane tracks do not believe in this recovery. That gives me even more confidence that it is real.

Especially interesting since the last multi-year bearishness in Market Vane, here’s a different perspective from Yang’s MarketTells.com:

Historically, this group has a strong track record of turning bearish on stocks (meaning a reading below 50%) ahead of virtually every significant selloff of the past twenty-five years (see long-term chart.) They were bearish ahead of the ‘87 crash, ahead of the ‘98 mini-crash and held a persistently bearish outlook from early 2000 right up until mid-2003. Since then, they’ve maintained a consistently bullish outlook. As I said, they have an enviable track record… it will be most interesting to see if their outlook rebounds out of this territory, as it did in recent years, or if this group finally throws in the towel and switches to a bearish outlook. Should that occur, it would be a significant red flag for the stock market’s longer-term outlook.

Looking at a long term chart of Market Vane’s bullish percentage along with the S&P 500, what I see is a great contrarian indicator. The only unique characteristic of Market Vane is that it settles itself into multi year ranges. As long as you use some sort of bracketing structure around it, like for example bollinger bands, it is useful. Trying to out think a simple sentiment survey will not yield much. And in any case, it is only one single tell. Much more important is the total picture that all indicators paint together.

Investor’s Intelligence
One of the longest running sentiment surveys, the Investor’s Intelligence keeps track of newsletter writers’ sentiment. Because of the nature of their business, newsletter writers are by and large a bullish bunch. After all, positive, cheerful newsletters sell better.

So it is very rare to see more bulls than bears. Usually stock market inflection points are carved out when the bull ratio (bulls divided by the sum of bulls and bears) nears 50%.

This week the II bears finally increased to 37.4% making the bull ratio reach 52%. We haven’t seen this many bears in this sentiment indicator since last August and early 2003 when the bull market was launched. The difference is that while that occurred after a catastrophic fall in prices, this level of fear came as a result of a 12% decline from all time highs.

All in all, this is the sort of fear based capitulation I’d like to see. It came a bit late but no doubt it was a result of the swoosh down we saw last week as the S&P 500 broke through its 1460 technical support area.

Low Volume Skepticism
Having seen prices rally sharply higher, the perma-bears are clinging to their last possible straw: low volume. I would advise them to throw a glance towards the general direction of a calendar. We are in the thick of the summer doldrums.

And yet, the average volume on the exchanges is anything but anemic. In fact, this is the highest volume August for many many years. The spike in volume accompanied the capitulation as the smart money rushed in to buy what the weak hands were selling.

Now they are sitting back and waiting. As Jesse Livermore used to say, it is the sitting that makes you money.

So was that capitulation? I don’t mean today’s gangbusters market. I mean yesterday’s rollercoaster ride.

Let’s see…

Stop, Hammer Time!
The intraday reversal gave us a beautiful, textbook hammer candlestick. Using the traditional Japanese candlestick theory, after a downtrend this is a portent of the end of selling pressure. Although the low could be tested - especially with Friday’s gap - a hammer is a bull’s friend.

Market Internals
The market was deeply oversold. The NYSE cumulative intraday TICK reached levels only seen right after September 11, 2001 and during the bear market bottom in the summer of 2002.

The New High Lows Index for Nasdaq reached 2.29%. Simply put, almost no highs, and almost all lows. To find a more extreme reading, we’d have to go back to the fall of 1998. Which as you know was a major market bottom.

Only 9.4% of the stocks in the S&P 500 index closed above their 50 day moving average. And only 34% above their 200 day moving average. The NYSE McClellan Summation index got as low as it has been since the bear market bottom.

My Kingdom For T-Bills
During Thursday’s nail biter of a session there was an exodus from anything risky towards the least risky asset. Theoretically risk free Treasury Bills. The run on government paper pushed the yield down to 3.86% for 3 month bills. To make things worse, due to an unexpected rise in tax receipts the government issued less paper. This sudden imbalance is extremely rare. And it only happens during panics (which… say it with me now… form bottoms).

I felt uncomfortable agreeing with Cramer, but I think this is one of the reasons why the Fed acted this morning. Commercial paper was being shunned. They stood up and basically told the market We got your back. For a bit it was touch and go, but my world feels right as rain again.

Margin Bulletin
I got a message from my broker warning me that positions in VIX futures and futures spreads could face an increase in margin from the CFE. I’m thankful for the headsup but I don’t trade these securities. I did notice that margin tweaking is a sign of inflection points. Just something to tuck under the hat.

Retail & Institutional Fund Flows
This is fascinating. According to the estimates from TrimTabs, we just had the highest weekly outflow since right after September 11, 2001. For about two years now the US mutual fund investor has been shunning the US stock market. But this week they pulled $12.8 billion out of US equity mutual funds.

According to TrimTabs, since the beginning of year, mutual fund buyers have been net sellers of stocks resulting in outflows of $35 billion in the last 4 months. The only time we saw similar outflows of this magnitude was during June 2002 and September 2002. You know what that was, right?

Strangely enough, bonds are the most popular asset class along with money market funds. They are even more loved than international markets. Bonds have seen an estimated $92 billion inflow since beginning of year this year.

That’s the retail side. What about the institutional mutual fund asset allocators? I’ll give you one guess.

They’ve been diving into the US market with the same intensity as the retail side has been escaping from it. So the smart money is buying and the emotional, dumb money is selling. Watch the video for more details:

Commitment of Traders
The most recent COT report dovetails with the fund flows data. We are seeing a continuation of the commercials going huge net long and the small speculator going the other way. Whether the futures market or the stock market, the two sides have clearly outlined their positions. There is no doubt where they stand.

What, Me Worry?
Which gives me a possible explanation for the sentiment picture. Perhaps the reason we are not seeing a total all out panic and despair from the retail investors during this downturn is that they simply don’t have any real vested interest in the outcome.

If we go by the COT and fund flows, they have very very few chips on the table. So why would they care? why would they get scared? Most of their money is squirreled away in cash equivalent and bonds and international markets. Unlike the 2000 top, they have very little invested in the US. Why would they even really care if the US market ticks up or down a few percentage points?

Hoo-Kay… let’s see. Why is this a buying opportunity for someone with a medium to long term time horizon?

Glad you asked.

Fund Flows
We already know that the vast majority of investor’s money is flowing oversears, eschewing the US equity market. But with the recent market decline, investors are now pulling money out in a panic. According to TrimTabs, they withdrew $7.6 Billion last week. That sort of panic is similar to what we saw in late February 2007 when investors pulled $6.5 Billion.

Insiders Are Buying
Meanwhile, insiders have been scooping up unloved shares at a pace not seen in 3 years. That was in August 2004 as stocks hit an intermediate bottom. Ask yourself, is there anything insiders know that we don’t? Who would I rather side with? insiders or Mom’n'Pop investors who are ruled by emotion?

Sentiment
Speaking of emotion, while sentiment surveys are not yet in, I suspect that we’ll see a marked decline in bullishness and a rise in bearishness. Only one is in so far and it shows a tilt towards bearishness as fear grips investors. But looking at unorthodox places like newspaper headlines and media stories we can find a lot of negative chatter.

“Usual Suspects” Show Fear
The usual indicators that most people turn to are showing fear: volatility indices and the put/call ratios. And the increasingly popular % of stocks above a moving average.

Scapegoat: Sub-Prime Mortgates
Everytime the market falls, a convenient reason is trotted out to explain it in a sound bite. Today’s is the subprime mortgage market. In the spring it was China’s fault. They sneezed. We caught a cold. While it is ugly out there in the subprime market, risk profiles are returning to more normal levels.

It is not the end of the world as we know it. According to the credit default swap market, we are in full blown panic right now. As a result the financial sector has gotten crushed to absurd valuation levels. Over the long term, this is one heck of a great buying opportunity as people panic and throw out the baby with the bathwater.

Market Internals
Popping the hood on the market and taking a peek inside we see that the internals are also showing panic and fear. At levels which historically have installed important market bottoms. Take a look at the new highs, versus new lows. The advance decline line, likewise has found a high probability buy zone here.

The Commercials
Like the insiders, they know something. They aren’t telling exactly what, but who cares? All we need to do is follow what they do. That’s the most convincing argument they can put forth: money where their mouth is. The commercials have steadfastly and consistently increased a ginormous net long position. Who do you want to side with? them or the little guy who was buying calls like crazy just before the market dove off?

Fundymentals
Let’s not give the technical tools all the fun. How abou the IBES model? It is showing that equity markets are very cheap here. Yes, very. And cheap. Don’t like the IBES? Fine. How about that the market’s forward multiple is 14.7, which is a little below its 20 year average? Still think the market is inordinantly expensive and in need of a fall?

Bond Market
A lot was made of the bond market’s fall in June 2007. But guess what, the yields spiked on the 10 year and 30 year Notes have fallen dramatically. Don’t believe me? Pull up a quote. If you’re a chart and system junkie, take a look at the 30 day rate of change for the bond market.

Traditional Technical Analyisis
Price, moving averages, trendlines and good ol’ support and resistance. The market has fallen to its 200 day moving average, where it has found footing before several times. The uptrend is still intact. And the S&P 500 is right at the support (previous resistance) line at 1460(ish) - check out the graph.

Bad News Trio
Bad news is everywhere: American Home Mortgage is in bankruptcy, Sowood Capital, imploded taking with it hundreds of millions of investor’s money. And just today rumours were swirling of Beazer Homes’ (BZH) bankruptcy. As far as I know they were unsubstantiated. But the important thing is that the negative headlines and fear is palpable. Just this week there was an article on the Wall Street Journal asking if the bull market was over? This cluster of negative articles and media attention accompanies market bottoms, not tops.

The IPO Market Speaks
When things get frothy, the IPO market goes insane. Crazy ideas are funded and taken public. Remember the turds from the bubble years? e-Stamps anyone? Right now though we have a healthy IPO market. One that is open and functioning without being irrationally exuberant. That bodes well for the market in general as this study from Thomson Financial shows.