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Sentiment Overview: Week Of September 26th, 2008 at Trader’s Narrative

As opposed to just a few weeks ago where I had to scrape bits and pieces of information to put together a sentiment overview, this week we have an over abundance of data and indicators, so lets get started:

Hedge Funds Net Short
Based on information from Carpenter Analytical Services, the average hedge fund was just until recently net short to the same degree as mid 2004 and early 2003. I’d suggest taking that with a grain of salt because hedge funds are by their very nature nebulous and non-transparent. Carpenter “reverse engineers” hedge fund positions starting from their performance. While this metric is far from 100% dependable it does provide limited insight into how the brightest traders are positioned.

More important than the snapshot of hedge funds being net short, I’d like to see the market continue to go lower, or level off, while the hedge funds aggressively change their posture and go net long. This is what we saw in mid 2003 just before the S&P 500 took off like a bottle rocket from the bear market depths it had sunk to. On the other hand a dangerous situation brews if the market continues to meander or even manages a feeble rally while hedge funds continue to aggressively bet against it.

Cash Is King
Combined with the net short positions, hedge funds are strangely hiding a significant amount of assets in cash. According to analysts at Citigroup, hedge funds have now socked away $600 billion in cash with $100 billion of that in money market funds. This is highly unusual because assets are invested with hedge funds with the view that they will be invested in the most sophisticated methods allowing for market neutral returns.

The extreme cash position is a sign of temporary uncertainty as the whole market seems to be news driven now. It may also be a result of the new short sale restrictions (although hedge funds can easily circumvent them, it may not be politically expedient to do so). On the plus side, it represents a formidable force that is being kept in reserve, if and when the bull market resumes.

The massive cash horde is also matched by the mutual fund industry with the average equity fund (non-index) holding 5.4% of assets cash. According to Morningstar, this is slightly below the record of 5.5% set in late 2007.

ISEE Sentiment Index
Last week after pointing out that the ISE options sentiment was acting strange, the ratio started this week with a jump to 136 (from a low of 66). As retail option traders rushed to buy call options over put options, the market tumbled down ~1255 (S&P 500 Index). I continue to wait for this indicator to give us a true showing of fear from the retail option traders. We came close last week but with this week’s recovery in the ISE sentiment index, unfortunately, it seems we will have to muddle through until perhaps we see a sharp waterfall decline take us through to real panic.

CBOE Put Call Ratio
This option metric is also showing a muddled picture. As I mentioned briefly last week, the CBOE put call ratio fell to 0.51 but since then it has quickly recovered, as if all the talk of financial Armageddon is simply being ignored by main street investors. This level of complacency is not something that gives a contrarian much confidence that this new found stability in the market holds promise.

Corporate Insiders
From the Vickers Weekly Insider Report, corporate insiders continue to act bullish in the face of the market decline. The ratio of insiders purchase and sale of company stock is as bullish as it was in mid July 2008 and towards the end of the bear market in 2002. Although this is a reliable and quantified indicator (as opposed to bearish or bullish sentiment) it should be projected into an intermediate time frame and not used to make short term trading decisions.

Sentiment Surveys
According to the American Association of Individual Investors (AAII), there is less pessimism this week with only 45.74% bears and slightly higher bulls 34.04% (than last week). I’m not happy to see this because the market is actually lowered than where it closed last week! So to see an uptick (even a small one) in bullish sentiment is disappointing… if one expects this to be the floor for the market.

The Investor’s Intelligence sentiment survey which measures where newsletter editors stand (as judged by ChartCraft) is little changed with 37.5% bulls, 40.9% bears (a slight decrease).

Mark Hulbert, of the Hulbert Financial Digest, suggests that the best performing market timers are significantly more bullish now than their less astute peers. This may seem to be a bullish sign but for the fact that the top performing market timing newsletter editors have been more bullish for most of the market decline. The key, I suspect, is to watch for the deviation between the two camps to widen to a significant enough gap to merit contrarian attention.

The mood is discernibly grumpy on Wall Street. And the financial sector is not the only one to be punished mercilessly. Take for example, Research In Motion (RIMM) which announced earnings that barely managed to disappoint due to slightly higher expectations. Even though they are a profitable company, they were taken behind the shed with a an almost 30% decline in one day!

Having said that, considering the historic and unprecedented situation, it is unusual to not see every single sentiment indicator not stuck at its most extreme reading possible. Arguably, we still have not seen full blown panic selling to completely wash out all the weak hands.

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