Sentiment Overview: Caught in the Crosswinds

Includes: DIA, QQQ, SPY
by: Babak

What a week! Between the Fed’s much awaited QE2, the mid-term elections, payroll data and the rocket ride higher, the sentiment cross-currents are getting difficult to read. Here’s this weekly sentiment overview to (hopefully) provide some insight:

Sentiment Surveys
The AAII survey of retail investors showed that the extreme optimism we saw last week took a small step back. The bulls declined to 48.2% while the bears increased to 29.8%. This provided a bull ratio of 62%, down slightly from the previous week’s 70%.

AAII bull ratio Nov 2010

The interesting aspect of this development is that the survey was taken on Wednesday, one day before the big rally. At that point the S&P 500 index has managed to climb about 15 points and yet optimism ebbed slightly and bearishness rose. In a sense, this shows a morsel of reluctance on the part of the average US investor to jump in with wild abandon.

I look forward to next week’s AAII sentiment survey results because if the market continues to rally or hold at this level and we see the retail investor sentiment continue to lag, then this provides a strong argument for further gains. But if we suddenly see the AAII bull ratio shoot higher (perhaps even above 70%) then the opposite argument can be made.

Investors Intelligence
There was little change in this week’s II survey: the bulls gained a sliver to 46.7% while the bears remained unchanged. The bull ratio was also little changed from last week. So we remain at approximately twice as many bulls as bears. Certainly an overall bullish picture but not at the excessive level (3:1) that usually corresponds to major or intermediate tops. For a chart of the Investors Intelligence bull ratio see last week’s sentiment overview.

Hulbert Newsletter Sentiment
Another survey of newsletter editors is finding much less enthusiasm. According to Mark Hulbert, keeper of the Hulbert Stock Newsletter Sentiment index, while there was an expected jump in optimism after Thursday’s rally, the HSNSI is still lower today than it was in either April or January 2010.

The current reading of 45.7% suggests that the market timing newsletters are recommending that their clients have less than half of their portfolio invested long the stock market. To put that in perspective, that is slightly less than what they were recommending in early September 2010, and significantly less than the 65% long exposure they were recommending in both January and April 2010 where the market stumbled onto intermediate tops.

Hedge Fund Sentiment
According to the latest TrimTabs/BarclayHedge survey of hedge fund managers (conducted in October) 35.7% are bullish on the S&P 500 while 38.8% are bearish. This is about twice the bull ratio for this sentiment index compared to May 2010. The majority of those surveyed are neutral regarding 10 year US treasury bonds while almost evenly split between bull/bear regarding the future of the US dollar.

Public Sentiment
Last week we looked at several indexes which showed that consumer confidence is still languishing at extremely low levels. When we look at sentiment surveys like the AAII one above it is easy to forget that it is a small sub-set that has ’skin in the game’ or at least interest in the game. These specialized surveys do not truly represent the average American’s feelings towards the stock market.

A wider survey conducted by CNBC last month shows a startling amount of distrust and unease on the part of the average person when it comes to investing in equities. The poll was conducted in mid October and found that only 37% believe it is either a “somewhat good” or “very good” time to invest in equities. The majority (51%) believe this is either a “somewhat bad” or “very bad” time to invest in the stock market.

Astonishingly, this is approximately the same amount of pessimism that was recorded by a similar survey in the depths of the 2008 credit crisis and bear market! In December 2008, 52% of those polled believed it was a “bad time” to invest in the stock market. Apparently, a 44% gain in the S&P 500 index is simply not enough to make a dent in their apprehension.

Fund Flows
We can see this entrenched skepticism towards equities in the weekly fund flow data that shows that almost without fail, every week the average mutual fund buyer is cashing out of US domestic funds and piling into bond funds instead.

For the past 4 weeks we’ve seen a slight change in this trend. The pattern of preferring bonds over equities remains but now mutual fund investors are reacting to the emerging market bull market and investing more of their money overseas. According to Lipper FMI, the most recent data for the week ending November 3rd had domestic funds receiving just $100 million of inflows while international funds received $1.1 billion.

IPO Market
One of the important signs of the health of the financial system is the quantity and quality of initial public offerings. During the 2008 bear market the IPO market shut down completely. Then right around the lows in the spring of 2009 we saw the first glimmer of life return to the IPO market. Then by fall 2009 it was clear that normalcy was slowly but certainly coming back.

So far in 2010 we’ve had 120 IPO pricings. That is the best IPO market since 2007 when in the first 7 months of 2007 there were approximately the same number (124) of pricings. Most of the action has been outside of the US market, especially concentrated in China and Hong Kong. Of course the record setting issuance ($19 billion) of Agricultural Bank in the summer was a milestone but there have been dozens of Chinese or Asian related IPOs since.

The IPO market hasn’t completely returned to normal but the doors are open once again and investors are more than willing to pick up companies that have a compelling narrative, reasonable valuations and attractive fundamentals. All in all, the foundation for continuing improvements have been laid.

Option Sentiment
For some time now we’ve been discussing the strange phenomena that both the ’smart money’ (OEX put call ratio) and the ‘dumb money’ (for want of a better term) have been leaning into the long side of the market. This is rare, although I can’t quantify it for you yet. Usually when the retail option traders are buying calls like mad, the institutional traders are taking the other side and leaning short.

This week the intensity of the call buying by the smart money was incredible. The 5 day moving average of the OEX put call ratio fell to 0.54, implying that this crowd had bought almost twice as many calls as puts in the preceding trading week. That is astonishingly bullish. It is in fact even more bullish than they were in early 2009 at what they sensed was the start of a new bull market:

OEX put call ratio Nov 2010

George Soros is famous for saying that when you see an opportunity, you should be as greedy as a pig. Well, these option traders certainly did their best to emulate an appetite of porcine proportions for calls. On the last trading day of October and on the first day of trading in November they traded approximately 3 times as many calls as puts! When you consider that this was just days before the massive rally on Thursday it becomes apparent why this indicator is looked upon as the ’smart money’.

Of course the OEX put call ratio has walked back from those extremes. The 5 day average is now 0.70 - quite low but off the recent extremes. The 10 day moving average is 0.71.

The strange turn of events may have a simple explanation. Perhaps, even though both the smart money and the retail traders are buying they are doing so for very different reasons. The retail traders, I imagine, are as usual chasing a hot market. The smart traders may be buying because they know that the Fed is on their side.

Turning to the retail option traders, the ISE Sentiment index continues to hover around 200 calls for every 100 puts bought to open a trade. The 10 day average closed at 204.30 just about where it has marked previous tops (red line in chart):

ISE sentiment 10 day moving average Nov 2010

The outlier was April 2010 of course when the (day moving average of the) ISE Sentiment spiked to a high of 249. Of course, then the ’smart money’ was not leaning the same way but in exactly the opposite direction - in late April 2010 the 5 day moving average of the OEX put call ratio spiked to 1.56.