Sentiment Overview: Anticipating the Elections

Includes: DIA, QQQ, SPY
by: Babak

This week’s sentiment overview outlines the bullish overtones of the market. As we await the results of the mid-term US elections and the imminent arrival of the second wave of quantitative easing from the Federal Reserve, it may be useful to recall the old Wall Street adage to “buy the rumor and sell the news”.

Sentiment Surveys
Contrarian investors should sit up and take notice as we are finally getting a definitive extreme reading from the weekly AAII sentiment survey. According to the survey, the majority of retail US investors believe that the stock market will be higher 6 months from now: 51.2% were bullish and only 21.6% were bearish.

As I mentioned yesterday, this is the first time we are seeing such a larger bullish camp since May 2008 (53%) - this was one of the intermediate peak retracements during the recent bear market. The S&P 500 topped out at 1426 and fell 15% by mid-July 2008.

As well, the bull ratio is now slightly above 70% - something we hadn’t seen for almost 3 years. That is to say, relative to bears, the AAII didn’t have such a large portion of bulls since February 22nd, 2007. This was just before the S&P 500 corrected 6%, falling from 1459 to 1374.

AAII bull ratio Oct 2010 update

This week’s survey result is the lowest number of bears since mid-January 2006 (19%). In response the S&P 500 was able to trundle along for a few months basically moving sideways but it peaked in May 2006 about 2% above the January bullish extreme date. From there it declined for the rest of the summer. The result was that basically the first 8 months of 2006 were a wash.

Of course, during strong bull markets it can go much higher but in recent years we’ve seen a range for the bull ratio between 30-70% so this is definitely pushing the upper boundaries. As the examples above illustrate, historically when the AAII survey has been this lopsided towards the bullish camp the equity markets have had a tough time. According to Bespoke, from 1990 onwards, when the bullish levels has been between 50-60% as it is now, the S&P 500 index has returned an average of -0.19% in the following month (49.61% were positive).

Investors Intelligence
In contrast to the retail investors, the newsletter editors measured by ChartCraft actually were slightly less optimistic this week. The Investors Intelligence survey showed 45.6% bulls and 24.4% with the rest expecting a correction. This produces a bull ratio of 65%, down from last week’s 67%:

investors intelligence bull ratio Oct 2010 update2

Put another way, we are now seeing less than twice as many bulls as bears. During recent market history, tops have coincided with approximately three times as many bulls as bears.

NAAIM Survey of Manager Sentiment
Active money managers in the NAAIM survey reduced their portfolio’s long exposure this week. The average fell to 57.7% from 72% and the median ticked down to 75% from 80%. The market’s plateauing at the 1180 level on the S&P 500 index apparently is enough to warrant a bit of caution. On the other hand, the dispersion of responses was quite high suggesting that there is little consensus among money managers.

Consumer Confidence
Various measures of confidence paint a picture of the average US consumer mired in pessimism, even as the economy has stabilized. The frustrations are understandable as unemployment remains high.

The ABC News Consumer Comfort index inched up to -47 (again) this week but it has fallen the dark levels of 1992-1993:

ABC News Consumer Comfort Index Oct 2010

By way of comparison, the CCI reached +38 in the heydays of early 2000. The depth that it has fallen to may not be unprecedented but the length of time it has been down here is. With the current week’s result this is the 131st week that it has been below -40. Here’s a shorter term chart, showing how the index has very slowly meandered higher from early 2009:

ABC news CCI short term Oct 2010.

There is a similar gloomy outlook from the Conference Board Consumer Confidence. It gained 1.6 points from last month to reach 50.2 but it is still mired in the same general vicinity for many months:

conference board consumer confidence Oct 2010.png

The Reuters/University of Michigan survey of consumer confidence (preliminary) fell to 67.9 from 68.2 in September. This is far from June’s 76 but we are back once again to levels last seen in late 2009.

Fund Flows
According to TrimTabs, for the week ended this Tuesday (October 19 - October 26) retail mutual fund investors added $759 to domestic equity funds. The sum is small but what is more notable is that this is the first time since April 2010 that US investors had added, rather than withdrawn from US equity mutual funds. Knowing just how horrible retail investors are at timing the market, this should make every bull think thrice.

According to the latest data from ICI, US mutual fund investors withdrew $202 million from domestic equity funds. That is a preliminary number subject to revision. Foreign equity funds continued to receive favor this week with an additional $2.2 billion - the seventh consecutive inflow. While this may be the first signs that retail investors are not fleeing equities, they are continuing to pour money as usual into fixed income. So far this month both taxable and municipal bond funds have gained an additional $20 billion.

Lipper FMI’s data also suggests that investors are adding money to equities. For the week ending October 27th Lipper FMI reports a net inflow of $780 for domestic equity funds and an inflow of $1.237 billion for global markets (with the majority going to emerging markets - $999 million). Equity funds also received an additional $3.3 billion via ETFs.

Option Sentiment
The option market is a bit of a conundrum at the moment - at least for me. That’s because both the ’smart money’ and the ‘dumb money’ are doing the same thing, buying calls.

The ISE Sentiment index which measures the retail option trader activity was very bullish this week. Even though the market went nowhere fast, for 3 days the ISE sentiment index was above 200. So it seems that the retail option traders want to really push the market higher. The average ISE index (equity only) for this week is 197 and the 10 day average is 191. But things are actually a bit calmer than they were two weeks ago.

The S&P 100 index (OEX) option market is normally considered the ’smart money’ playground and so it is puzzling to see them also favoring the long side. The 5 day moving average of the OEX put call ratio is 0.73 which is quite low and normally corresponds to market bottoms, not tops:

oex put call ratio Oct 2010 update