Here is this week’s rundown of sentiment data for the market:
US retail investors as measured by the AAII weekly sentiment survey were decidedly less optimistic this week. Only 29.8% were expecting higher prices 6 months forward, a decline of 11.5% points from last week. More notably, the proportion of those expecting lower stock prices rose to gain a majority at 50.9%. We should bear in mind that the responses to this survey were submitted before Thursday’s positive close.
The net effect of these changes is that the bull ratio is now at 37%, the lowest it has been since November 2009:
The above chart shows the AAII bull ratio compared to the S&P 500 index (SPX). During bull markets, such declines in optimism correspond well with the end of short term corrections. But during bear markets, even pitch black pessimism can lead to nary a rebound. You can see an example of this in January 2008 when the bull ratio fell to just 25%. It wasn’t until March 2009 when a complete washout - at 21% bull ratio - gave us sufficiently lower prices for an intermediate bottom.
For those wondering if this is the end of the cyclical bull and not just a mere correction, the reaction of the stock market to such a level of pessimism will provide an answer. If the market can muster enough strength to rise once more, then the cyclical bull market is still healthy. If on the other hand we see a weak rally that quickly gives way to fresh lows, then this tells us that the market needs significantly lower prices to entice serious buyers.
ChartCraft’s measure of weekly newsletter sentiment shows a continuing erosion of the bullish camp. This week the bulls fell to 39.3% from 43.8%;. The bear camp rose to 29.2% from 24.7% and the correction camp stayed unchanged at 31.5%. The bull bear ratio consequently declined to 1.35:1 - where it was at the February 2010 lows.
We are certainly seeing a considerable amount of ground shifting between the two camps but while we are at a point of correction, we are still not at a true extreme. That would be when the bullish camp gets as low as 26% and the bearish camp rises to 49%. So once again, this is enough of a shift for a correction to end but not enough for a bear market to end. The reaction to the sentiment change then depends on the type of market we are in.
Daily Sentiment Index
The Daily Sentiment Index (DSI) has fallen to 21% bulls from a high of 92% just a few weeks ago:
This level of optimism is lower than both the February 2010 and July 2009 corrections. But it is still far away from the abysmal levels seen at the March 2009 lows. We are either on the cusp of a significant recovery like those that followed the previous corrections mentioned or we are headed down even lower to truly bring in hopelessness before the market can bottom. I know I sound like a broken record by now but this is the running theme that I’m seeing in the recent sentiment data.
NAAIM Survey of Manager Sentiment
This measure of active asset managers’ sentiment has also fallen quite precipitously in the past few weeks. The chart below is of the median survey results (rather than the usual mean chart we look at) and shows the decline from 95% in early April to the current 27.5%:
The NAAIM median is below the February lows (30%) but still not at the lower extremes that it has reached historically. If you’ve been reading along so far, I’ll spare you the broken record routine. The other interesting data point from the NAAIM this week is that the survey respondents are very sure of their answer as a group. We can see this in the low standard variation within their responses. Just as they were as a group confident that the market was looking good at the top with 95% being long in early April, they are equally sure that the market now warrants a cautious stance.
Hulbert Newsletter Sentiment
I’ve already discussed the lightning fast retreat of stock newsletter editors that try to time the market, especially those that specialize in the Nasdaq. According to Mark Hulbert, these market timers have gone from being extremely bullish (+80%) to being mildly bearish (-45%) in the span of a few weeks.
This cyclical bull market has been brought to you by central bank liquidity gushing through trading desks, hedge funds and algo trading. The retail investor, once a mighty force in the stock exchange, has decided to sit this out. According to TrimTabs, from March 2009 to April 2010 individual US investors have withdrawn a total of $20.7 billion from domestic equity funds.
In April it looked like the retail investors were dipping a toe back in the waters. According to ICI domestic funds saw an unfamiliar inflow of $5.5 billion. Then came the so called “flash crash” on May 6th. To the tortured psyche of the US retail investors, this was just too much.
We only have partial data for May but so far, the three weeks in the month are showing a complete and abject capitulation. US domestic mutual funds are seeing outflows of more than $16 billion. By the end of the month, if the trend continues, that could be $21 billion. We haven’t seen such a stampede out of equity mutual funds since October 2008.
The other intriguing development is that US retail investors are also giving up on bonds. While fixed income had monopolized inflows for the past year, this month we saw a week with net outflows and for the 3 weeks in May the total inflows is only $7.7 billion. That is paltry in comparison to the $30-$40 billion we have seen going into bond funds on a monthly basis.
When Selling Begets Selling
According to Lipper, US investors withdrew $5.3 billion from domestic funds this past week. That is the largest outflow since this bull market began. If we include ETFs along with mutual funds, the sum grows to a gargantuan $16.7 billion hemorrhage - for just one week. That is the worst showing for the past 8 years. The retail investor’s current mindset is unmistakable. And before we rush to a contrarian interpretation, we have to realize the importance of retail fund flows for the continued health of a bull market.
We have already looked at the historically low levels of cash that the average mutual fund manager has on hand. This illiquid state coupled with potentially persistent selling on the part of clients could trigger a cascade reaction. If the stock market doesn’t rebound higher and if sentiment continues to decline, then we could see a vicious cycle unfold. Considering the asymmetrical reaction of retail investors to the May decline in stock prices it isn’t implausible to imagine the following situation. If prices fall lower, especially if they do so in a spike, retail investors could be so scared that they rush to sell with renewed vigor, tipping managers over the event horizon and leading to more and more selling that feeds on itself.
This is a very negative scenario and more than a few things would have to occur in confluence to get us there so I put the probability at remote to extremely small. In any case, it is important to think about this potential scenario and prepare contingency plans on the downside.
The daily option sentiment fluctuations this week were a bit puzzling. For example, on Wednesday, when the S&P 500 was carving out an inverted hammer candlestick, the ISE sentiment index was 192 but the next day, when we had a significant rally, the ISE sentiment index was lower at 156. And then when the market fell, it rose once more to 193!
This sort of thing hurts my head. I’d rather just look at the smoothed 10 day average of the equity only ISE sentiment index:
The low of the short term average was hit last week (147). Since then it has minutely risen to 153. This level of sentiment from retail option traders is slightly lower than what we saw in February’s correction but it is far from an extreme.
The CBOE put call ratio is showing a similar picture with the short term (10 day) moving average of the equity only ratio at 0.69:
This is just an anecdotal observation but consider that the most widely read article this week on MarketWatch.com -the popular investing website run by Dow Jones Company - is the one written by Paul B. Ferrell titled “Crash is dead ahead. Sell. Get liquid. Now.”
One common fallacy we are all susceptible to is seeking out evidence or opinion that agrees with our already formed position and ignoring that which could prove us wrong. So the fact that so many investors are attracted by such an article tells us a little something about their state of mind. Take a look at the other popular articles and you’ll see they are all varying degrees of negativity as well.
Finally, a brief overview of gold sentiment. I’ve already delved a little into this last week and again most recently yesterday. On the euphoria side is the roll out of gold dispensing vending machines produced by the Germany-based company, GOLD to go.
On the other hand (with a much longer perspective) is this chart of gold compared to the S&P 500 index:
Source: John Roque via Barry Ritholtz
A few persevering readers may recall that we looked at this chart late last year. I’m a bit wary of extrapolating the S&P 500 back to 1928 - when it just did not exist! Nevertheless, the main point still stands.
A true bubble top of epic proportions is usually accompanied by these sort of headlines: Hard Money May Be On Way Back and Gold: Frenzy drives price to $630; dealers in Toronto are swamped.
Magazine Cover Indicator
As Steffan pointed out recently, two major German investment/finance magazines are promoting gold in their coverage. I haven’t been able to find the relevant article or cover for FOCUS money magazine but Der Aktionar’s cover is extremely bullish, screaming “Gold: Last Chance (to Buy)”.
Considering the parabolic nature of gold priced in Euros, and the extremely negative sentiment towards the Euro (DSI at 2%) a more significant correction wouldn’t surprise any contrarian investors. The other cover is from the May 10th issue of FOCUS money with the title: “Euro-Alarm!” and a Euro coin embedded in the lit siren.
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