Saturday, August 1, 2009

Investor Sentiment: Dumb Money Bullish Again!

Over the last 4 weeks, the S&P500 has gained a little more than 12%, and during that time, investor sentiment, as measured by the "Dumb Money" indicator, was neutral. Prior to last month's huge run up, the "Dumb Money" indicator was in bullish territory (i.e., bear signal) for 10 consecutive weeks, and during that time the S&P500 lost 3.5%. This week (or rather after last month's monstrous surge), we find the bulls ready to buy high and sell higher again as the "Dumb Money" indicator has moved back into an extreme bullish reading.

The "Dumb Money" indicator is shown in figure 1. The "Dumb Money" indicator looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investor Intelligence; 2) Market Vane; 3) American Association of Individual Investors; and 4) the put call ratio.

Figure 1. "Dumb Money" Indicator/ weekly

Typically, extremes in bullish sentiment are a bear signal unless this is a bull market circa 1995 or 2003. I still have my doubts. Even though the recession may end soon, a recovery seems to be a long ways off. The next 3 months of the year are generally poor ones for equities. Technically, we are all over the map. A close over the simple 10 month moving average is an encouraging sign no doubt, but an over bought, extremely exuberant market is not my "cup of tea". I would wait for a more risk adjusted entry point.

From a bigger picture standpoint, the market is playing out this week as I suggested last week:

As investors are not buying into the rally, one might conclude that the rally will march onward and upward until they do, and then it will rollover. That seems likely. (We are here now.) However, it is hard to imagine that prices will continue making gains at the pace seen over the past two weeks. (Last week's gain was the least in 3 weeks.) I still stand by the sell signal and expected spike in prices that I wrote about two weeks ago. (This is now three weeks ago.) The recent "breakout" in prices will eventually be seen as a better time to sell rather then a new launching pad for a bull market.

From my vantage point, much of the past 3 weeks the market has rallied on short covering. My evidence for this comes from the Rydex asset data. One of my favorite aspects of the Rydex data is the amount of assets in the bullish and leveraged funds versus the amount of assets in the leveraged and bearish funds. Not only do we get to see what direction these market timers think the market will go, but we also get to see how much conviction (i.e., leverage) they have in their beliefs. See figure 2 a daily graph of the S&P500 (symbol: $INX) with the Rydex leveraged bulls (green line) versus the leveraged bears (red line) in the lower panel. Typically, we want to bet against the Rydex market timer even though they only represent a small sample of the overall market.

Figure 2. Rydex Bullish and Leveraged v. Bearish and Leveraged/ daily

Since the low on July 8, there have been 17 trading days; there were 9 trading days in which the amount of bearish and leveraged assets was greater than the bullish and leveraged assets. In other words, our representative market sample (i.e., the Rydex market timers) were betting against the market. These days are identified with gray vertical lines in figure2. During these 9 trading days the S&P500 was up almost 11%!!! Not surprisingly durng the other 8 days when the bullish and leveraged assets exceeded the bearish and leveraged the market gained only 1.14%. These days are identified with the green boxes over the price bars.

So we have 9 tradings days of more bears and than bulls where the market gained 1.22% per day versus 8 trading days of more bulls than bears where the market gained 1.14% the entire time. This seems like short covering to me. This would also be consistent with our "this time is different" scenario. Short covering necessarily isn't a bad thing, and it is how most rallies are started any way. The flip side to higher markets on short covering is that buyers tend to evaporate with higher prices, and that appears to be the pattern since May, 2009. When the Rydex bullish and leveraged assets are greater than the bearish and leveraged assets there is no short covering to propel prices higher, and we see lower prices chasing the bulls back to the sidelines.

I don't doubt the power of the market or the power of the trend to humble this poor analyst, and I use the word "poor" in the figurative sense not literal!!! However, patience is important here as the market is over bought and as investor sentiment is bullish to an extreme. I am willing to be patient for that more risk adjusted entry.

The "Smart Money" indicator is shown in figure 3. The "smart money" indicator is a composite of the following data: 1) public to specialist short ratio; 2) specialist short to total short ratio; 3) SP100 option traders. The "smart money" is neutral.

Figure 3. "Smart Money" Indicator/ weekly

Lastly, I am on holiday this week and the posting will be more infrequent than normal. Have a great week! Stay cool!!

10 comments:

dacian said...

Ok, so what can we conclude from the last two posts here?

1. Based on Faber model (risk management) filtered with the "inflation signal" (real or perceived) we have a buy signal, but we wait for a pullback; a stop at 6.5% lower should be set.

2. From sentiment point of view and market action (this is short covering, investors not buying), a pullback is quite probable.

There is also your call on "this is not the launching pad of a new bull" which is somewhat opposed to this buy signal of the Faber model (I understand we use Faber more for trading and risk management and we don't care whether bull or bear market).

Thanks Guy for the work you put into all this!

PS:

"I use the word "poor" in the figurative sense not literal!!!"

What do I have to understand, did you invest these last weeks the opposite of your calls on the blog? Just kidding... :)

Have a nice weekend!

Guy M. Lerner said...

Dacian:

Your conclusions and interpretation of what I have been writing are correct. Your #1 point is correct and #2 point is correct; and this is still not the launching pad for a new bull market.

As an aside, I read something the other day by Ned Davis of Ned Davis Research, and it attempted to define those 7 things seen at a market bottom that leads to a secular trend change. In spirit, this would be similar to the "next big thing" indicator as Davis's definition included fundamental plus technical metrics and mine is only technical. His conclusion: cyclical bull within a secular bear. But didn't say how long this cyclical bull would go on.

So back to your comments....when you take 1 and 2 together, a buy on a pull back becomes a "just in case" we are going higher; I know my risk and I am buying against that so to speak. Honestly, I am willing to be patient to let the sentiment picture play out.

The only thing that I cannot gauge is the gov't's role to interfere and prop markets up as there is a belief that higher markets creates confidence, which leads to consumer spending. I have recently read some things that would verify that notion more concretely. Hey, we would all like Dow 20,000 but every time you get prices divorced from reality, reality sets in eventually.

In any case, what happens if we don't get the pullback? I guess we don't, but I am not willing to compromise on my approach.

Several other things: 1) I will always execute or trade the things that I write about in this blog; why write about it, if I am not doing it. I will never do one thing and write another. So if I am looking for that pullback to buy (even though I am unsure what things will be in a couple months) then I will be buying. The only thing that you didn't ask me about is how much capital I am willing to commit to such a trade, and this will end up being risk adjusted to the other assets (commodity, Treasury yields, gold, international exposure) that I have in my portfolio. This is the stuff that benefits from the Dollar is going lower.

2) by "poor" I meant several things: a) I have been on the sidelines with regards to equity market (SPY) exposure; so I am not losing money as I don't like to bet against the market; it is hard enough getting the direction right on the long side. I have other exposure that has been doing well so my "poor" is only relative to not being in equities and the sense that I didn't nail the exact bottom or top so to speak; b) "poor" also is relative in that how bad could things be as I am on vacation with my family and we have our health (knock on wood) and I am able to do the things I do. In the bigger scheme of things there is no "poor" here.

Thanks for the support and the positive comments; I really do try to provide my take on the markets and support it with research and numbers; I try to be consistent from week to week.

dacian said...

I was having a question actually and forgot to drop it in my comment.

"As investors are not buying into the rally, one might conclude that the rally will march onward and upward until they do, and then it will rollover..."

For traders (professional for most of them) to cover, some buyers needs to "force" that move up; so this 50% short covering still must have some big money bidding on prices in order to become possible.

The question is, who in your opinion is bidding if investors are still not buying? We see it's not "dumb money" as you call it as they're wrong; smart money is neutral (they don't buy neither they sell), so who is it then?

You mention in your comment the government propping things. Is it the govt. then? Which arm of the govt.?

Guy M. Lerner said...

I don't have any knowledge of the government buying per se, but our elected officials have so much of a vested interest in seeing stock prices higher - what left is there to manipulate? I say this because every media outlet has this angst when the the market drops more than 5% over two weeks.

Zero Hedge Blog had a good analysis of who is buying and how the notion of money on the sidelines is a bunch of nonsense. Follow this link:

Click Here

Kevin said...

Guy,

Is there any way I can subscribe to your "Dumb Money Indicator?" Or build it myself? I think it's literally worth money.

Kevin

Guy M. Lerner said...

Kevin

Thanks for the compliment but unfortunately for me, it is completely free!

Anonymous said...

Hi, where can I check Rydex Bullish and Leveraged vs Bearish and Leveraged on a daily basis? Is there a symbol or you just combine all data on your own? Thanks

Anonymous said...

funny... i came to the comments page just to see that Dacian already used the quote:
--------------------------------
I use the word "poor" in the figurative sense not literal!!!
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well, your bearishness in this mother of all rallies left yuor readers poor. Even if they were "just" out of the market...

Dacian said...

anon,

I don't want to polemic here, but

"well, your bearishness in this mother of all rallies left yuor readers poor. Even if they were "just" out of the market..."

I guess you don't really understand what this blog is about: it's about risk management and not day trading. FYI, this blog was bullish back in March based on market sentiment at that time, so readers had a chance to make some money.

How one is poorer is it stays out of the market is beyond me (except if we have an inflationary environment when paper money lose purchasing power, which isn't the case today).

Guy M. Lerner said...

Anonymous #1: Rydex has an archive page at this link:

http://www.rydex-sgi.com/products/mutual_funds/archive/DailyNAVsArchives.rails

Anonymous #2: I am not sure about leaving the readers poor; yes, I have been out of equities (i.e., SPY) and I have had a bearish bent towards equities since early May; from May to mid - July the markets were down and from mid July to present the markets have rallied 14% in 18 trading days, which is not normal. And so let's ask where do we go from here? Another 10% in 10 days? This may be great for day traders but even then I would suspect (as the Rydex data shows) that the last x percent of this rally has been short covering from day traders trying to time the top. Nonetheless, your criticism is always well taken here provided you are willing to provide some insight with that criticism.

In addition, while I would always love to nail the bottom and top every time and use leverage to boot, let's not forget other current "calls": 1) Dollar at risk for substantial move lower (made June 19) with a list of 4 or 5 sectors that would benefit; 2) "call" on Japan; 3) "call" on Treasury yields; 4) several sector calls on semi's, housing, airlines, networkers etc. well before other analysts; for example, I was talking semis when the SOX was at 220; Bespoke jumped on the bandwagon with SOX at 300.

Dacian: thanks for the support on this; and I know you understand that isn't so much where we are today but where we are tomorrow and the day after; so while everything is turning up roses today doesn't mean we will end up smelling good tomorrow; it is all about taking the appropriate risks at the appropriate time.