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 past week’s important sentiment data:

Stock Timing Newsletters
The Hulbert Stock Newsletter Sentiment Index (HSNSI) was at 27.5% at the start of the week. Meaning that the average stock timing newsletter was recommending to their readers that they be long the equity market with 27.5% of their portfolio. This is where they were the previous week, before the powerhouse performance that the stock market put in rocketing higher with 90-90 up days.

So from a relative point of view, that performance did nothing to impress the average stock timing newsletter editor. This is bullish from a contrarian point of view. On an absolute level however, the HSNSI is well above the -29.4% it reached in mid March 2008. But it isn’t yet yet high enough to give me concern.

AAII
The weekly American Association of Individual Investors sentiment survey has suddenly veered sharply into a bearish stance. It wasn’t that long ago that we had more than 50% of respondents in a bearish posture, but now that number has withered to only 28%. To find a time when the AAII survey was more bearish we’d have to go back to October 2007 when the market made its swing high.

Although it is just one measure of sentiment, it makes me uneasy. I’m glad that I’ve already reigned in my enthusiasm.

ISEE Sentiment
Inside last week’s sentiment overview I mentioned that the CBOE equity only put call ratio had declined to dangerous levels (for the bulls that is). That is confirmed by the ISE sentiment data.

On Monday it reached a high of 158 - meaning that retail option traders were buying to open 158 call options for each 100 put options. It has since fallen to 117 on Friday and the 10 day moving average is still fairly low but still, it does give me another reason to be cautious here.

Insider Buying
I’m talking about the legal variety here, the kind that is communicated to the SEC and tracked by various services like Vickers/Argus and Insider Insights. Insiders have been actively buying during the markets most recent fall. Since insiders have an intimate knowledge of their market and businesses this is a big positive sign. On the other hand, had they instead sold en masse while the market fell, it would mean that we were not close to a bottom and had more to go.

According to Argus’ data for the past two months, insider selling to buying is 1.40:1 - meaning that for every $1.40 equivalent sold by an insider during that time, $1 was spent on buying stocks. Since insiders are normally net sellers, any decrease in this ratio is what matters. According to Argus, it is bullish anytime insiders are selling less than twice what they buy.

To add another to the set of indicators that compare the present market conditions to those of the end of the 2002 bear market, the current insider ratio is very similar to what it was then.

Conclusion
So while in the medium to long term, the viability of a continuing rally is still looking pretty good, there are gathering signs that we may backtrack a little or pause before fully exploiting it.

Insider activity is a reliable metric which I haven’t discussed in a while. It is a bit quirky because by nature, insiders are net sellers. They get allocated shares as a pay package or through option incentives and they usually turn around and sell.

It is also natural for them to sell in a rising market. So in a bull market, seeing a rise in insider selling isn’t necessarily a harbinger of doom. In contrast though, insiders can tell us a lot more during market declines - like the one we’ve been having lately.

If insiders continue to sell or increase the pace as the market falls, this is a very negative tell for the market. In effect, the insiders are saying that things are probably going to get worse (so they want out now).

But if insiders start to buy during a down turn that has strong bullish interpretations. Although, when I say buy, what I mean in effect is sell less than the usual.

By comparing the buys and sells, we can track the relative sentiment of insiders. Last summer, just as the market was about to make a bottom, the ratio of insider sells to buys fell to 2. That is a very low number and it basically means that on average for every 2 shares sold, one is bought.

Remarkably, just as the market was peering into the abyss in mid August, according to Vickers Weekly Insider Report, the sell to buy ratio fell to an incredible 0.92!! This meant that there were actually slightly more shares bought than sold.

Since insiders are by nature net sellers, this is a very rare occurrence. The implications it has for the market are unmistakeably bullish.

Consider this other tidbit: the last time the ratio fell to less than 1 was in late 2002, marking with uncanny precision the end of the bear market.

I find it remarkable to see the market just below all time highs with such positive insider sentiment. The bull market doesn’t seem to care that it is long in the tooth, doesn’t seem to care about the sub-prime mess, or any other “logical” reason why it should not go higher and higher.

One of the key players in the stock market are insiders - those who work at a high enough levels in corporations and therefore are privy to sensitive ‘inside’ information about the health of the corporation, its clients, suppliers, competitors and the economy. Having access to such information firsthand provides them with an enviable edge.

As a group they apply this edge quite well and it is possible to piggy back on this edge by watching them carefully. The only caveat is their edge only appears in the intermediate to long term time horizon. And because of their nature, insiders are natural sellers (option grants, and such). So we have to calibrate our measures to account for this. As well, it is important to view their actions not in isolation but in terms of what the company’s stock has done. For example, if insiders continue to sell shares after an already considerable fall, this bodes badly for a potential rebound.

A common metric is the ratio of insider sells to buys compared over time. This is one of the measures that Argus Research compiles. According to Vickers Weekly Insider Report (one of Argus’ clients) this ratio was at around 7 in April. Now it stands at approximately 2. This means that whereas in April we saw 7 sells for each buy, now we see only 2 sells for each buy. When you keep in mind the inherent bias of insider activity towards selling, you realize that this is quite bullish.

Interestingly enough, there is similar insider buying activity on the other side of the pond. Deutsche Bank analyst Bernd Meyer has put out a report which argues that strong momentum in insider buying has bullish consequences for the market in Europe.

So here we have yet another reason for a rally. But where is the confounded rally? Maybe it will show itself tomorrow after 2:10 pm. Or maybe not. All the reasons in the world mean very little when arrayed against the tape itself.

Source: IHT article, Mark Hulbert article.