Sentiment Overview: Week Of March 18th, 2011

The sentiment summary for this week:

Sentiment Surveys
Starting off with the usual suspects, the weekly retail investor sentiment measure from the AAII had more bears than bulls, something we haven’t seen since early September 2010. The AAII bulls fell to 28.5% and the bears rose to 40.1%. This pushed the bull ratio down to 41.55%, almost half of what it was at its recent peak in December 2010. Historically, important buy points have corresponded to bull ratio readings below 30%.

Perhaps more interestingly, the “Farrell Sentiment index” which is a re-working of the AAII survey data has now slumped very close to a buy signal (below 50%):

As a reader pointed out, it doesn’t really make sense to take into account the neutral weekly readings along with the pessimists. Using the Investors Intelligence data which for ‘correction’ instead of neutral would make more sense. But since previous buy signals using the AAII data for the Farrell Sentiment index has provided good entries, I thought it was worth mentioning.

Investors Intelligence
Unlike the retail crowd, the sentiment measure of stock market newsletter editors was little changed this week. The bulls stayed almost unchanged at 52.2% and the bears increased a smidgen to 22.3% (from 21.1% last week). While this could be interpreted as a preliminary sign of complacency on the part of newsletter editors, it is too early to convict them of being guilty of this.

NAAIM Survey of Active Managers
This survey of active money managers shows a large decline in market exposure this week in reaction to the weakness in the equity indices. The median exposure fell from its recent high of 97% to just 50% and the average exposure fell to 41% (from 75% last week).

This is a pattern that is to be expected after equity markets in general declined. Unless we see a tenacious insistence by the bulls, it will serve to keep the correction short and shallow. However, it does not indicate by itself that it is over.

Perhaps as interestingly as the large drop in bullish sentiment, there was also a significant change in the makeup of the survey results this week. Unlike the past several weeks where the respondents have tended to cluster together within a narrow range agreeing with each others’ take on the market, this week there was a very large variability in the survey answers.

Hulbert Newsletter Sentiment
Mark Hulbert, the creator and keeper of the various Hulbert Newsletter Sentiment indices reports that the recent market turmoil was enough to send the market timers scurrying for safety. This is a bit strange since the other indicator of newsletter editors shows an overwhelming sense of complacency.

Short term market timers tracked by the Hulbert Stock Newsletter Sentiment Index (HSNSI) were recommending 62% exposure to the market to their clients in early November 2010 and 58% in late February 2011. That has now fallen to just 43%.

The market timers focused on the Nasdaq and tracked by the Hulbert Nasdaq Newsletter Sentiment Index (HNNSI) have reduced their market exposure even more. The HNNSI fell from a recent peak of 73.3% in Febuary to just 20% this week.

While this change in sentiment definitely shows that we are not seeing these newsletter editors cling to their previous convictions, the current readings are not low enough yet to provide me with any real urge to buy. My contrarian senses would start tingling if and when these same market timers start to suggest to their clients to go net short the market. For example, consider that last summer the HNNSI fell to -45% (just as the correction was ending).

Daily Sentiment Index
Similar to other sentiment surveys covered in our overview, the DSI has also fallen sharply. The DSI for the S&P 500 index fell this week to 61% and for the Nasdaq to 59%. But also similar to other metrics, this decline only shows that the crowd is giving up to a large extent. We still don’t have enough pessimism to warrant the furnishing of a meaningful floor for equity prices. Consider that at the end of last year’s summer correction the DSI for equities fell below 20%.

Merrill Lynch Survey of Fund Managers
According to this month’s survey of institutional money managers by Merrill Lynch, sophisticated investors are stepping away from risk and equities. A major cause of this new found caution is a change in their views towards the US economy.

Of those surveyed, a net 45% are overweight equities, in February it was a net 67%. As they move away from equities, funds are being parked in cash: 18% are overweight cash while last month they were net 3% underweight. Sentiment towards fixed income remains relatively unchanged.

Even so, investors have not changed their preference for sectors within equities nor rotated out of high beta sectors into more defensive ones. As a group they are overweight technology and cyclicals while underweight staples and utilities.

This might be strange since there was a sharp fall in the number of respondents who believe that the US economy will grow: from 52% last month to 21% this month. As well, 24% expect corporate margins to fall. This is an abrupt about face not seen since the survey began keeping track of this question. At the beginning of the year 10% were expecting operating margins to rise.

Globally, investors are warming up to emerging markets once again and are even less worried about the Chinese economy and its real estate bubble. But they remain neutral compared to overweight at the start of the year.

Mutual Fund Flows
According to ICI, outflows from US equity funds continued this week but at a much slower rate. Retail investors redeemed a net $1.1 billion from domestic equity funds (compared to $3.2 billion last week). Foreign mutual funds continued to receive approximately the same rate of inflows as last week ($1 billion).

According to Lipper FMI, retail mutual fund investors are aggressively buying into the declines in international markets. This week there was a net inflow of $2.1 billion into global funds.

According to ICI data, retail investors also returned to fixed income with the same gusto we’ve observed before by adding $3.9 billion to taxable bond funds. They are still withdrawing a net amount from municipal bond funds but it has now slowed to a trickle compared to the torrent of money that we saw a few months ago. Last week retail investors withdrew $681 from municipal bond funds. The small outflow is matched with a continuing restricted supply. This has served to maintain the municipal bond market stable overall.

Junk Bonds Flows
After 14 weeks of consecutive inflows which caused the risk premiums to shrink to microscopic levels, the return of risk is also bringing a small amount of normalcy to the high yield bond market. According to Lipper FMI, retail investors withdrew a net $471 million from junk bond funds this week.

Even so, valuations continue to be strained. The Merrill Lynch High Yield Master II index indicates junk bonds trading at 103.15 – a small decline from last week’s 103.9 cents on the dollar but the largest since the Irish sovereign debt crisis sent a ripple through credit markets in November 2010.

Taking a page from the municipal bond market’s playbook, corporate bond issuers has sharply curtailed offers this week. According to Dealogic issuance is down 40% in the past two weeks compared to the last two weeks of February. As deals get postponed due to international events, political unrest and the spike in oil, it remains to be seen how much of this the market can take before cracking.

Option Sentiment
As the S&P 500 index broke below its short term congestion and its 50 day moving average, the CBOE (equity only) put call ratio spiked up to 0.79 – that is the highest since June 24th 2010 (when it hit 0.82). The short term moving average of the put call ratio reached 0.68 which is the highest it has been since late August 2010 when the equity market ended its correction.

The equity only ISE Sentiment index which is a call put ratio indicated major fear as it fell to 99 on Wednesday. This implies that, just barely, there were more puts being bought to open a trade than calls. But that number was later amended to 122 so I’m not sure if it was correct. I’m trying to get confirmation from my contact at the ISE.

If the 122 daily value is correct for Wednesday, it would still be the lowest daily value since November 29th 2010. And it helped the 10 day moving average of the ISE Sentiment index to continue to fall this week, ending at 178. That’s a huge decline from mid-January where it topped out at 267.

For several weeks I’ve been beating the table about the S&P 100 index (OEX) put call ratio and especially its open interest put call ratio. Both ratios for the OEX declined this week. The put call ratio fell to 1.66 from a recent high north of 2.0 and the open interest ratio reached a high of 1.78 on Tuesday and started to decline – something we haven’t really seen for a while.

Since the short term moving average of the open interest put call ratio had been on an unrelenting tear for the past few weeks, the fact that it is pausing here is important. It suggests that institutional traders are – for the moment – taking their feet off the brakes.

While I’ve been monitoring the rare spike in the S&P 100 index open interest ratio, the put call ratio for the Nasdaq 100 ETF (QQQ) has also been acting notably. Since it was confirming the signal from the OEX I didn’t really think it important to mention.

Similar to the OEX put call ratio, the put call ratio for the Nasdaq 100 ETF (QQQ) is better interpreted as is, without a contrarian twist. Usually when it rises to a high, the Nasdaq index has a tough time rallying and instead either corrects or at best, plateaus.

During the past few months we’ve seen the 10 day moving average penetrate above 2.5 on three separate occasions. And the historical pattern has held true with each of those occasions being followed by price weakness. What interests me now about this pattern is that while the Nasdaq market has continued to be weak, the put call ratio is once again rising quite rapidly.

On Thursday there were twice as many puts traded on the QQQ as calls and on Friday more than 3 times as many. The short term moving average has yet to reach the 2.5 level but it is rising very sharply. On Friday the 10 day moving average closed at 1.90 and if it continues to rise like this, it will reach the critical 2.5 level again within a few trading days.