Sentix Sentiment: Less Pessimistic But Still Cautious

The current sentix sentiment readings for various indexes and asset classes suggest that investors are still cautious while moving away from the recent pessimism:

Among world indexes, the two with the most bearish sentiment are Japan (Nikkei) and China (CSI). Among commodities, crude oil is the least loved.

With the Greek sovereign debt crisis coming to a head, it isn’t surprising to see the European banking sector get clobbered in the sentiment readings:

Of course, from a contrarian perspective this means that we’ve seen or are about to see an important low. Remember that market bottoms are made during times of pessimism and negative news. By the time the crisis is resolved, the rebound will be well underway.

The relative Banking index is close to reaching the 2009 bear market lows and finding support during the gloom and doom related to the Greek debt crisis.

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Sentiment Overview: Week Of June 17th, 2011

Below is the summary of sentiment data for the financial markets:

Sentiment Surveys
Even though the S&P 500 index was slightly lower, the weekly survey of retail US investors was more optimistic this week than last. This is surprising since we usually see sentiment reflect market moves. Those expecting stock prices to be higher in 6 months rose to 29% (from 24.4%) while the bears decreased to 43% from 48%. The change was small but enough to push the bull ratio up to 40% from 34%.

This is 43% the average bull ratio and therefore still a very low level of optimism overall. The four week moving average of the bull ratio was basically unchanged and the lowest since late July 2010. For the chart, see last week’s sentiment overview.

Investors Intelligence
The story remains the same with this indicator. Just as last week optimism is waning but there are still far too many newsletters who believe the current market weakness is merely a ‘correction’. While the bulls have receded from a peak of 57% in April to 37% this week, the bears are still too few in number at 26% to provide a meaningful signal.

Sentiment & Market Tops
Mark Hulbert wrote an interesting article earlier in the week in Barron’s: “Is the Bull Market Over?“. He looks at the behavior of the sentiment surveys mentioned here (Investors Intelligence, Hulbert Newsletter Sentiment, and AAII) and compares their pattern at major market tops.

His conclusion is that these sentiment surveys are coincident indicators. Based on this he suggests several ways that we can check to see if a recent top (such as the one we’ve just had) is the end of a bull market. One way to tell is if the peak in sentiment and the peak in stock market prices are separated by more than a few months. In such a case a major top is unlikely.

Another way to confirm a major top is to check if sentiment has reached historically extreme levels. If instead sentiment indicators have peaked at lower levels then a major market top is unlikely. Based on these two key variables, Hulbert concludes that we can’t rule out that the May top will mark a ceiling for prices for some time.
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Rydex Traders Throw In The Towel

Regular readers will remember that in late January I pointed out that based on the trading activity within the Rydex leveraged ETFs, there was a market top in sight. A few weeks later in February it did indeed arrive.

Then again in early May I pointed once more to the same indicator and suggested that we were about to see have another market top. This time the market reached a peak immediately.

In the light of those two prescient warnings, the market weakness we’ve experienced is understandable. The S&P 500 index is down more than 7.5% from its peak and the Nasdaq Composite has retraced more than 9%.

So what is this accurate indicator telling us now?

Instead of showing you the raw Rydex Leveraged ETF ratio as before, I thought we’d instead look at the 100 day stochastic of the ratio. This simply takes the ratio and converts it into a range bound indicator with a maximum of 100 and a minimum of 0.

As you can see from the chart, the indicator is now almost back down to its lower extremes. Earlier this week the lowest it reached was 24. That is still a bit away from the lows it reached last summer but it is enough to warrant lightening any short positions.

Other measures of Rydex trading activity show even more positive bias. For example, if we look at the various Rydex sector mutual funds, we see that less than 10% of them have current assets higher than their 50 day moving average. This means that Rydex traders are exiting almost all sectors en masse. Historically when we’ve seen this level of reluctance to hold Rydex sector funds, a major low wasn’t too far away.

Another measure of Rydex activity focuses on the flow of funds into bullish mutual funds, both leveraged and non-leveraged funds. The pattern in this indicator is also bullish because Rydex traders are seriously paring their long exposure to equities.

By itself this or any other indicator is not to be trusted. But taken in concert with the other signs that we’ve seeing, including the option trading activity, this important contrarian indicator based on Rydex trading activity suggest that the market is about to find support at these levels.

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Option Traders Most Bearish Since 2009 Bear Market Bottom

In last week’s sentiment overview I mentioned that the options market was showing a major shift towards puts, which from a contrarian perspective is bullish for the market. With today’s decline, that move has accelerated. So much so in fact that we are now, arguably, seeing the most fearful market since the bear market bottom that launched the cyclical bull market we’ve enjoyed for the past few years.

The CBOE equity only put call ratio hit a high of 1.11 today – the highest since November 19th 2008 when it reached 1.16. That pushed the already fast climbing 10 day moving average to 0.83 – the highest since late January 2009:

The CBOE put call volume data can vary significantly over time. During particular periods, what was once considered a ‘ceiling’ gets shattered and a new range is set. And at other times, the put call ratio seems to sink lower and lower, breaking all previous definitions of a ‘floor’. We can normalize the ata to avoid any confusing that this straying effect could cause over time. Credit for this idea goes to Jason Goepfert who has a great service at SentimenTrader. It is a similar idea to the normalized breadth indicator I mention here.

The idea here is simple, we take a short term moving average and we use a long term moving average to orient it so that it self-corrects. I chose the short term moving average I usually use (10 days) since it represents two trading week’s worth of activity. For the long-term moving average I used 125 days since that is about half a year’s worth of trading days. Of course, you can play around with different moving averages but it should give you almost the same picture as below:

The normalized CBOE put call ratio does a good job of finding important inflection points (but it missed the March 2009 low). And the current reading confirms that what we are seeing is truly extreme.

Regular readers will remember the OEX put call volume ratio as well as the OEX open interest put call ratio that I’ve mentioned multiple times since February. This ‘smart money’ indicator had been flashing a warning sign for months and with hindsight we can see its effectiveness once more as the S&P 500 index has been basically flat in that time period.

The ISE put call ratio also showed a large shift towards put options today. But the move on that option exchange was not as pronounced, reaching only 0.87 (or 115 expressed as a call put ratio). The 10 day moving average likewise is not as extreme as the CBOE market. But the retail crowd is by far preferring put options which is a strong contrarian signal.

Sentiment surveys meanwhile show a continuing decline in optimism. The Investors Intelligence survey of newsletters has been the most stubbornly bullish among these in recent times. The bears this week increased to 26% (from a recent low of 15.7% in April) and the bulls declined to 37% (from a recent high of 57% in April). The usual suspect of sentiment indicators will arrive with the rest of the week and as always, they will be in the weekly sentiment overview on Friday.

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Sentiment Overview: Week Of June 10th, 2011

Here’s this week’s sentiment summary:

Sentiment Surveys
Retail investors in the US continued to become more bearish this week. Only 24% expected higher stock prices while 48% think prices will weaken in the next 6 months. Since late December 2010, we’ve seen bearishness rise by a factor of more than 2.5 times. The four week moving average of the AAII bull ratio is now down to almost the same level as the trough of last year’s correction.

It is important to remember that different sentiment conditions arise during different market conditions. Considering that the 2008 bear market conditions were extreme and that
if bull market conditions still apply, this is a significant contrarian signal. We should expect a low here based on a washout in sentiment.

During the bear market, stock prices become much more ‘oversold’ in order to attract strong-hands (red arrows). But during bull market conditions, important lows occurred at this relatively modest level of gloom (green arrows).

Investors Intelligence
ChartCraft’s II Advisor Sentiment index is also showing an amelioration in the bullishness extreme that we saw recently. The bulls decreased to 41% while the bears reached a 10 weak high of 23%. At a bull bear ratio of 1.8:1 this sentiment gauge of newsletter editors is still far from providing a contrarian signal. Usually we expect to see market lows accompany ratios of 1:1 or lower.

While a significant portion of newsletter writers have defected from the bullish camp, we are still not seeing enough of them becoming outright bearish. A large portion of them (36.5%) believe this is merely a “correction”.
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US Home Prices Approaching 1980’s Lows (Priced In Gold)

One of the major reasons consumer confidence continues to be low is the weakness in home prices. During the good times, positive home equity not only bolstered both consumer confidence it allowed the US consumer to spend much more than they earned.

Now the liquidity cycle is reversing itself. But even among these dark days, there is an inkling that the worst may be over.

Below is a chart showing the median single family US home price, priced in gold (one ounce). If you consider the US dollar to a dead currency walking and gold to be real money, then this chart shows that US home prices are close to reaching multi-decade lows and support.

The current price of a US home in gold is 106 ounces or approximately $162,000. That’s an 80% decline from the 2001 peak of 601 ounces.

Source: Chart of the Day

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Technical Indications Of A Short Term Bottom

Once again, a little known technical indicator is signalling the arrival of a short term bottom for equities. This is a new twist on an indicator that measures the percentage of component stocks closing above a certain moving average each day. As far as I know, I was the first to suggest the use of a ratio to compare two different moving averages – one short term and the other long term. In fact, this was one of the very first things I wrote about way back in 2006: Timing the Market with Above Moving Average Ratios.

It may be somewhat inelegant label (and quite a mouthful!) but it has been a very good compass for the equity markets. And that’s the reason why I keep referring to it as one of the most useful technical gauges. Most recently it provided a great signal at the spring correction. Once more, the ratio has fallen to almost the same depths:

The chart above compares the percentage of S&P 500 index individual components which closed above their 50 day moving average divided by the same which closed above their 200 day moving average. As you can see, when the ratio spikes below 0.5 things are generally oversold and ready for a bounce back. The chart includes data as of Monday’s close and today’s action has moved it upwards, but only slightly.

At times this indicator can be completely wrong of course. This happens when the denominator and numerator get pushed out of their normal ranges. A perfect example was the depths of the bear market in 2008. During those periods, I prefer to rely on the Coppock Curve to provide a buy signal. But it is important to distinguish between this indicator – which is a short term one – and the Coppock Curve or Coppock Indicator – which is a long term one.

Because of the negative seasonality and end of Fed purchases (also known as Permanent Open Market Operations) it is important to not confuse this technical signal as anything but short term in nature. After five down weeks, there are some whispers of a crash and we’ve already seen one major measure of retail US investor sentiment fall to levels it had not seen since August. And then there is the generally supportive option market activity.

The RSI is another technical indicator that is also suggesting that we should expect an oversold rally. It closed recently just a tad above 30 – a level where the equity market has found support so many times during this cyclical bull market.

But other technical indicators are suggesting that we’re seeing a massive loss of momentum. The Bullish Percent index which measures the percentage of S&P 500 index component stocks at a point and figure buy signal have fallen to fresh lows for the year and the lowest since October 2010. The percentage of S&P 500 index stocks above their 200 day moving average, itself an important indicator of momentum, is also waning.

After remaining within a very narrow band throughout most of the cyclical bull market (between 95%-85%) it has now fallen to 72%, the lowest since November 2010. Finally, the cumulative advance decline lines are looking tired. All this suggests that while the market is short term oversold, we’re seeing a more intermediate shift occur as well. Rather than being all encompassing, it looks like the bull market is leaning into its last chapters, characterized by a much more selective market of stocks rather than a stock market.

I think this aging bull market still has some life left in it and I expect at least a short term bounce. As for whether we’ll see a repeat of last’s year’s summer action, it is too early to tell.

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