Sentiment Review: Time Heals All Wounds?

Stocks suffered another week of losses. The S&P 500 Index (SPX), which fell below its October lows and to its lowest levels in more than 5 years on Thursday, lost 6.1 percent over the past five days. After a grueling 16.75 percent loss in October, the S&P 500 is down another 9.9 percent in November. The slide is once again stirring up bearishness among investors. However, unlike late October, sentiment is no longer dominated by panic and fear. A general sense of bearishness, negativity, and despair seem to better characterize the current mood. In that environment, a sudden turnaround or a V-shaped bottom that sometimes follows a protracted decline seems less likely.

Most indicators suggest that bearishness rose since our last sentiment update. For example, the CBOE Volatility Index (VIX) rose. The market's so-called "fear gauge" finished Friday up 6.48 to 66.31 and its best levels of the trading session. VIX is up from 56.1 the week before.

The ISE Sentiment Index (ISEE) fell to extremes Wednesday. The ISEE measures daily call buying divided by put buying on the International Securities Exchange (ISE). It fell to only 67 Monday and to one of its lowest levels in recent months (surpassed only by a 66 on September 18). A reading of 67 suggests that call buying is running about two thirds of put buying on the ISE, which is today's largest exchange for trading equity puts and calls.

Defensive trading was seen on the Chicago Board Options Exchange (CBOE) as well. The CBOE put to call ratio, which tracks the day's put volume divided by call volume for trading on the CBOE, finished the day above 1.00 four times in the past week and the ten-day average rose to 1.06 from .98 last Friday. The rise in the ratio suggests that investors are once again leaning more heavily on the put side of the options chains, which generally happens when anxiety and pessimism are on the rise.

Yet, while the VIX, the ISEE, and rising put-to-call ratios are all consistent with rising levels of bearishness, sentiment is still much different than in late October. For example, at that time, the aforementioned CBOE put-to-call ratio spiked to 1.26. Figure 1 shows the trend. At 1.06, it is well off the October highs. Similarly, while the VIX is higher than last week, at 66.31 it is significantly below the record highs near 90 seen in late October.

click to enlarge

Figure 1: CBOE Put to Call Ratio (10-day Average).

The sentiment surveys continue to show more bears than bulls, but the readings are not as extreme as they once were. According to Investors Intelligence, 31.9 percent of those surveyed are now bullish, compared to 30.3 percent the week before. Bearish sentiment fell from 48.3 to 46.2 percent. On October 22, the survey read 22.2 bullish and 54.4 percent bearish.

Over the past two weeks, I've noted here that the current market environment had turned from extreme panic and fear seen in October to one of despondency and despair. Consequently, it was unlikely that the market could stage a dramatic V-shaped recovery as the market had already been "washed out" by panic, but the general sense of discouragement, disinterest and disengagement on the part of many investors made a quick rebound unlikely. "Instead, no one event is likely to end the bear market. It seems like it will probably take a series of events and might take a significant amount of time before investor confidence is restored."

Moreover, until investor confidence returns to the market and the extreme levels of bearishness begin to dissipate (over a period of weeks or even months), the vicious cycle of fear can continue to feed on itself as money flees equities and the de-leveraging continues. According to the Times Online Thursday, Hedge Funds lost a staggering $100 billion during the month of October, "as panic-stricken investors rushed to withdraw their capital." Consequently, these funds, which depend on leverage to achieve market beating returns, are forced to unwind trades to raise cash.

But it's not just hedge funds, the five trillion dollars in open-ended stock mutual funds is also a problem. Open-ended mutual funds have very low ratios of cash. According to the Investment Company Institute, the average fund held only 4.7 percent of its assets in liquid assets at the end of September 2008. Now that many investors are awakening to the fact that passive investment management, or simply buying the same stocks as an index, is not the ticket to wealth, these funds are at risk as well.

The extreme volatility seen this week, particularly on Friday, hints at ongoing fund redemptions. The Dow Jones Industrial Average staged a stunning 447 point advance during the second half of trading, but that gain was entirely wiped out in the final thirty minutes of the trading session. Twenty-eight of the Dow thirty were hammered for big losses. The action doesn't hint at rational decision making. Nor is it consistent with the extreme panic and fear seen in October. Instead, it is a painful process of de-leveraging that is being fed by high levels of bearishness, negativity, disengagement, and despondency. A sudden change of psychology or a V-shaped recovery seem unlikely in such an environment. Instead, it is likely to take time for the equity market to mend itself.

Fortunately, the options market is holding up great and there are a variety of strategies that offer limited risk and interesting opportunities based on specific price targets for stocks and sectors. See what others are trading by looking at the hundreds of strategies we wrote about last week alone.

Comments

[kris23:]

Sentiment for the major indices has been bearish for the past few weeks but is seeing an up turn today. Sentiment for the NASDAQ, DJIA, and SP500 appears to be more bullish today according to www.predictwallstreet..../ sentiment meter which processes millions of investors predictions in real-time. I believe this may be a temporary up turn, but could be a small lead out of bear territory.

2008 Nov 17 12:57 PM