A lot has changed since the January 6 installment of Sentiment Review. At that time, it seemed like “a period of exceptionally quiet trading has lulled investors into a sense of complacency that, by some measures, has not been seen in years.” Since that time, another wave of volatility has swept through the equity market and the S&P 500 is down 100 points, or 10.7 percent.
A number of different factors have conspired to motivate the latest round of selling in the equity market. Obviously, a lot of the focus is back on the problems in the financial world after Citi (NYSE:C) made a deal with Morgan Stanley (NYSE:MS) for Smith Barney and Bank of America (NYSE:BAC) said it needed more capital to digest its acquisition of Merrill Lynch. A pessimistic research note from Morgan Stanley about HSBC (HBC) and a Deutsche Bank warning about hefty fourth quarter losses helped raise anxiety levels towards the financials as well.
While the headline risk from the financial world is affecting trading, the tone of the market has also changed a lot over the past two weeks. During the month of December, investors seemed to shrug off bad economic data and the major averages were able to move higher, even in the face of the grim headlines. However, that changed beginning with the disastrous ADP jobs numbers released last Wednesday. Now, bad news is once again being treated as…well…bad news.
As volume returned following the quiet final two weeks of December, so did volatility. After falling to three-month lows below 36 in early January, the CBOE Volatility rallied back to close above 50 for the first time since December 16 on Thursday.
The rally in the VIX is not the only indicator that suggests investor angst is back on the rise. Bearish sentiment is higher in the latest sentiment surveys. According to the American Association of Individual Investors [AAAII], bearish sentiment rose from 35.06 to 47.37 last week. Bullish sentiment fell from 49.7 to only 27.63 percent. Investors Intelligence reports that bearishness rose from 34.1 percent to 34.4 percent. Bullish sentiment also increased, from 41.8 to 43 percent.
Meanwhile, the trading activity in the options market has turned decidedly more defensive. The total put-to-call ratio, which is simply the day’s put volume divided by call volume for trading across the US exchanges, finished above 1.00 during four of the past five trading sessions. The ten-day average is plotted below. It is moving back above 1.00 and significantly above the two-year low of .74 on January 6.
Finally, recent trends in the fund world point to higher levels of investor anxiety. According to AMG data, equity funds (excluding ETFs) saw net outflows of $10.9 billion during the final three weeks of December and less than $2 billion of inflows during the first two weeks of January.
A recent article in the Financial Times points to a more troubling chain of events. According to the latest statistics, hedge funds lost a net $150 billion, or 10 percent of their assets, due to customer redemptions during the month of December. The outflows come despite moves by dozens of hedge funds to suspend or halt withdrawals.
The return of forced selling on the part of hedge funds due to redemptions is one factor underlying the return of market volatility during the past two weeks. Moreover, it is happening after two weeks of quiet trading at the end of 2008 that had lulled investors into a sense of complacency. Now, levels of investor anxiety and bearishness are rising again. In a period of “de-leveraging” and shaky investor confidence, this trend poses serious challenges to the equity market in the short-term. In this context, it might be prudent to look for signs that some confidence is returning before leaning too far on the bullish side of the trade. Until then, directional butterflies, buy-writes, and spreads are good tools to consider when looking for money-making opportunities.