Investor Sentiment: Option #3

Since October 10, I have been singing a new tune and warning that "there is probably greater risk of a market down draft now than in past weeks," and on October 17, I even underlined these words for emphasis. I think this past week's high volume selling would qualify as a market down draft.

So let me take a momentary bow and then quickly get back to business here because as we all know, hubris in the market is rarely rewarded. I couldn't resist the opportunity to pat myself on the back, which means I am putting myself at risk for being kicked in the ass by the market. Some might even argue that even a broken clock is right twice day. I say let them argue. I will continue to put out data driven research that can be acted upon in a timely and profitable manner. And best of all, it's free!!

The real question market participants want to know is this: is last week's dousing of the bullish spirits just a bump in the road on the way to higher prices or are the wheels coming completely off the rally which will lead to much lower prices?

I vote for option #3 at least in the short term, and option #3 is really what I have been stating for the last month:

"Equities are for renting not owning at this juncture. I am not calling for a market top, but prices should trade more in a range, and if you intend to play on the long side, it will be important to maintain your discipline (for risk reasons) and buy at the lows of that trading range and sell at the highs to extract any profits from this market. The upward bias still remains as long as investor sentiment is still extremely bullish, but there is probably greater risk of a market down draft now than in past weeks."

The ascent of the rally clearly has slowed over the last 8 weeks, but predicting that was the easy part. Whether we go sideways or much, much lower from here is a bit more difficult to say. We know that the excesses in bullish sentiment still need to be unwound, which suggests more downside to come. How else do you convert bulls to bears other than lower prices? As always, timing this possible descent is a little more problematic as the major indices (S&P500, NASDAQ 100, and Dow Jones Industrials) are only at the bottoms of rising trend channels. The Russell 2000 has broken below its rising trend channel, and maybe this is sign that the speculative fervor of this rally is over. In any case, with positive seasonal tendencies kicking in and prices still within an uptrend a bounce seems likely.

Overall, the sentiment data remains neutral to bullish, which is a bearish signal for the markets until these excesses are unwound. The trading range persists; we are at the bottom of that trading range. The market is still prone to sudden sell offs as we saw this past week.

The "Dumb Money" indicator, which is shown in figure 1, 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. The "Dumb Money" indicator shows that investors are extremely bullish.

Figure 1. "Dumb Money" Indicator/ weekly

The "Smart Money" indicator is shown in figure 2. 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 2. "Smart Money" Indicator/ weekly

Company insiders continue to sell shares to an extreme degree. See figure 3, a weekly chart of the S&P500 with the Insider Score "entire market" value in the lower panel.

Figure 3. InsiderScore Entire Market/ weekly

Figure 4 is a daily chart of the S&P500 with the amount of assets in the Rydex Money Market Fund in the lower panel. When the money market fund is flush with cash, one can assume that the Rydex timers (like market participants in general) are fearful of market losses. From a contrarian perspective, these are good buying opportunities. When the amount of assets are low (like now), these market timers are all in; one should be on the lookout for market tops. There is little buying power left. As of Friday's close, assets in the money market fund remain low, but they are off the levels seen earlier in the week.

Figure 4. Rydex Money Market/ daily

Rydex Market Timers: Bailing

Figure 1 is a daily chart of the S&P500 with the amount of assets in the Rydex Money Market Fund in the lower panel.

Figure 1. S&P500 v. Rydex Money Market/ daily

Figure 2 is a daily chart of the S&P500 with the amount of assets in the Rydex bullish and leveraged funds versus the amount of assets in the leveraged and bearish funds.

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

Ok, this is my brief interpretation of yesterday's price action. The big GDP print was already priced into the market, and it should not have been a surprise. With the Dollar down and everything else up again, one would can say two things: 1) nothing has changed; 2) if things are so good why are rates so loose?

In any case, with respect to the Rydex market timer (which is only a representative sample of market participants), there is no doubt that many are feeling relieved having been relieved of their losing positions. Let's put it this way, if you put on a short term trade on Friday or Monday, you got your head handed to you, and I am sure you were heard muttering, "I will never do that again - just get me out." So we get a nice pop yesterday on old news, and you are gone - out of the markets and licking your wounds and maybe a little light in the pocketbook. You sold into this 2% lift. The Rydex numbers appear to support such a notion as the number of leveraged bulls decreased and the amount of assets in the Rydex Money Market Fund slightly increased.

In sum, the Rydex market timer has been bailed out and is bailing out!

Modified Faber Model: Some Insight

As the prior post shows, we can improve a simple moving average strategy by going to cash when the trends in gold, crude oil, and yields on the 10 year Treasury are strong.

But for fun and education, let's pretend that the only time you are in the market is when the S&P500 is above its simple 10 month moving average and when our composite indicator that measures the trends in gold, crude oil, and yields on the 10 year Treasury is above the upper extreme line. This would represent the current market situation. See figure 1.

Figure 1. S&P500/ monthly

Going back to 1987, there have been 17 such occurrences. 11 were profitable. Your time in the market was about 15%. Such a strategy did not make money, and yielded the following equity curve. See figure 2. Clearly, this is not a favorable investing environment.

Figure 2. Equity Curve

Now let's look at the maximum favorable excursion graph or MFE. MFE measures how far a trade moves in your favor after you put it on and before it is closed out. See figure 3 for the strategy's MFE graph.

Figure 3. Strategy MFE

Look at the caret within the blue box. This represents one trade. This trade had an MFE or gain of 5% (x axis) before being closed out for a 0.5% winner (y axis). We know it was a winning trade because it is green caret. Of the 17 trades, 5 had MFE's greater than 4%; this is to the right of the blue vertical line. Only 4 of the trades had final gains of greater than 3%; this is above the red horizontal line. 3 of the trades (in the upper left corner of the graph, oval) had losses greater than 6%.

My interpretation of all this data is that this is not a particularly dynamic time to be investing. There appears to be a greater chance of losing money than winning. If a trade had an MFE greater than 3% it was likely to be profitable.

Overall, I still stand by the original assertion that stocks tended to under perform during times when the trends in gold, commodities, and yields on the 10 year Treasury bond are strong.

Modified Faber Model: Sell Signal

Back on June 29, 2009, I presented research that improved the efficiency of the Faber market timing model for the S&P500 by some 50%. By efficiency I meant that the new and improved model made more money with less time in the market and with less draw down. The research can be found in this article, "Inflationary Pressures Are A Legitimate Concern".

The gist of the research was that stocks tended to under perform during times when the trends in gold, commodities, and yields on the 10 year Treasury bond were strong. The Faber model is a simple moving average model, yet we can improve the model's efficiency (for the S&P500) by moving to cash when (real or perceived) inflation pressures are strong as measured by a composite indicator that assesses the trends in gold, commodities, and yields on the 10 year Treasury bond.

In other words, the modified model is only long the S&P500 when prices are above the simple 10 month moving average and when inflation pressures (as measured by the trends in gold, crude oil and yields on the 10 year Treasury bond) are not extreme. The original Faber model uses only the simple 10 month moving average to time its buy and sell signals.

As we end October, the trends in gold, commodities, and yields on the 10 year Treasury bond have been surging . The composite indicator that measures these trends is shown in the lower panel of figure 1, a monthly chart of the S&P500. Therefore, this constitutes a sell signal for our modified Faber model. Referring back to figure 1, I placed the recent bull market (2002 to 2008) buy and sell points from this strategy on the price graph.

Figure 1. S&P500/ monthly

Rydex Market Timers: No Material Change

Figure 1 is a daily chart of the S&P500 with the amount of assets in the Rydex Money Market Fund in the lower panel.

Figure 1. S&P500 v. Rydex Money Market/ daily

Figure 2 is a daily chart of the S&P500 with the amount of assets in the Rydex bullish and leveraged funds versus the amount of assets in the leveraged and bearish funds.

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

Rydex Market Timers: Reminds Me Of My Own Trading

In a show of doing the same thing over and over again or as I like to call it - hitting your head on the wall until it hurts - the Rydex market timer continues to anticipate a bounce in the market. This reminds me of my own market follies --only kidding!!

Figure 1 is a daily chart of the S&P500 with the amount of assets in the Rydex Money Market Fund in the lower panel. When the money market fund is flush with cash, one can assume that the Rydex timers (like market participants in general) are fearful of market losses. From a contrarian perspective, these are good buying opportunities. When the amount of assets are low (like now), these market timers are all in; one should be on the lookout for market tops. There is little buying power left. As of Tueasday's close, the amount of assets in the Money Market Fund was at its lowest value since the bull run began in March, 2009.

Figure 1. S&P500 v. Rydex Money Market/ daily

Figure 2 is a daily chart of the S&P500 with the amount of assets in the Rydex 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. Typically, we want to bet against the Rydex market timer even though they only represent a small sample of the overall market. As of Tuesday's close, the assets in the bullish and leveraged funds were greater than the bearish and leveraged by 2.38 to 1; referring to figure 2, this would put the green line greater than red line. When this ratio is greater than 2 the rally has generally stalled as noted by the maroon vertical lines.

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

Rydex Market Timers: Buying The Dip

The Rydex market timer, as a representative sample of investors, was buying yesterday's sell off.

Figure 1 is a daily chart of the S&P500 with the amount of assets in the Rydex Money Market Fund in the lower panel. When the money market fund is flush with cash, one can assume that the Rydex timers (like market participants in general) are fearful of market losses. From a contrarian perspective, these are good buying opportunities. When the amount of assets are low (like now), these market timers are all in; one should be on the lookout for market tops. There is little buying power left. As of Monday's close, the amount of assets in the Money Market Fund was at its lowest value since the bull run began in March, 2009.

Figure 1. S&P500 v. Rydex Money Market/ daily

Figure 2 is a daily chart of the S&P500 with the amount of assets in the Rydex 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. Typically, we want to bet against the Rydex market timer even though they only represent a small sample of the overall market. As of Monday's close, the assets in the bullish and leveraged funds were greater than the bearish and leveraged by 2.07 to 1; referring to figure 2, this would put the green line greater than red line. When this ratio is greater than 2 the rally has generally stalled as noted by the maroon vertical lines.

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

Treasury Yields: Observations

The only asset moving up over the last week has been longer term Treasury yields. This is odd especially in the face of equity market weakness and especially since demand for Treasury bonds has outstripped supply over the past year. So why are yields moving up now? Maybe yields are rising in anticipation of buyer fatigue as this week's record bond issuance comes to market.

This is difficult to know until it happens, but I can say for sure that yields are not rising because of inflation concerns nor are they rising because of strength in the economy. Yields generally rise after an economic expansion is well under way and they generally rise when the unemployment rate falls. The last time I checked, the unemployment rate was still rising; the economy had stopped its free fall, but visibility was less clear; and deflation seem to be a bigger threat than inflation.

Over the past several months, lower Treasury yields did not confirm the strength in the stock market, and this has been a glaring divergence that I have noted on more than one occasion. Now with weakness in the equity markets imminent (but not guaranteed), yields start to move higher. Hmm. I hope this isn't the new normal?

Technically, long term Treasury yields have the characteristics of an asset that could undergo a secular change in trend. This has been a theme that I have been on for over 10 months now, but in all honesty, yields have yet to show real sustainable strength. The best that I can say about my analysis is that I have said to avoid Treasury bonds for anything but a trade.

See figure 1, a weekly chart of the yield on the 10 year Treasury bond. The 10 year Treasury did trade to a yield of 4% back in June, but they fell back to 3.1% level before bouncing. Yields are above the prior weekly pivot high point at 3.437% and the down sloping black trend line, and it would be bullish for higher yields if there was a monthly close over the prior low pivot (on a monthly chart) at 3.432%. Yields appear likely to trade to the resistance zone between 3.856 to 4%.

Figure 1. $TNX.X/ weekly

Why yields should move higher has been a subject of much conjecture all year long. Nonetheless, increasing bond supply has been met by buyer demand, and the fundamental back drop (despite the stock market rally) really has not been conducive for higher yields. The technicals are at odds with the fundamentals.

Other observations are noteworthy. Figure 2 is a daily chart of the ProShares UltraShort Lehman 7-10 Year Treasury (symbol: PST), which seeks results that are twice the inverse of the daily performance of the Barclays Capital 7-10 Year U.S. Treasury index. The triple bottom is is quite noteworthy.

Figure 2. PST/ daily

Figure 3 is a daily chart of the ProShares UltraShort Lehman 20+ Year Treasury (symbol: TBT), which corresponds to twice the inverse of the daily performance of the Barclays Capital 20+ Year U.S. Treasury index. The double bottom is quite noteworthy, as indicated by the volume spike.

Figure 3. TBT/ daily

Another observation comes from the Treasury Inflation Protected Securities or TIPS market. As recently as last week, I was under the belief that yields were heading lower. Why? TIPS were headed higher. There is a very clear inverse relationship between TIPS and 10 year Treasury yields. This can be seen in figure 4. As TIPS go up; long term yields go down.

Figure 4. TIPS v. $TNX.X/ weekly

However, TIPS have not followed through (and I could be wrong!), but they haven't broken down completely yet. A monthly close below the pivot at 102.75 would be reason enough to abandon the notion of higher TIPS. See figure 5. A monthly close below this level would add credence to the notion of higher Treasury yields.

Figure 5. TIPS/ monthly

So let's summarize. There are lots of conflicting crosscurrents when it comes to yields on longer term Treasury bonds. Whether the current mini-lift in yields develops into a longer term sustainable trend is not certain as the fundamentals are at odds with the technicals. Nonetheless, betting on higher yields - because of the technical, secular tailwinds - may be the easier trade to make at this juncture.

President Obama's Economic Policy

This morning's sudden sell off on no apparent news must have the Obama economic team in a furor. After 7 months of unrelenting buying, the stock market actually went down. It was a terrifying sell off as the S&P500 lost 2% of its value in less than 60 minutes. This put the 401 k's and IRA's of average Americans at risk. Something must be wrong. What that something was wasn't readily apparent, but the economist in chief was going to get to the bottom of it.

Later that day, President Obama was seen asking the tough questions of his economic advisers in a conference room adjacent to the oval office. This chart was flashed on the far wall. Federal Reserve Chairmain Ben Bernanke said this was a graph depicting strength in the economy, but other more savvy observers said the chart had an uncanny resemblance to a 5 minute bar chart of the S&P500 Depository Receipts (symbol: SPY).

Figure 1. SPY/ 5 minute

Pointing to the area in question (highlighted by the bracket), President Obama said, "What the hell happened here? You guys told me that this thing would never go down. Don't you know that millions of 401 k's and IRA's and the economic vitality of this great nation hangs in the balance?"

Larry Summers spoke up. "Well there was a problem, sir."

President Obama: "You told me that there weren't going to be any problems. What was it?"

Larry Summers again: "Well, it was Tim's day to man the buy button, and apparently, he had to go to the bathroom."

President Obama interrupts: "For 1 hour?"

Mr. Geithner: "Was it really that long?"

President Obama: "Look here (pointing to the chart). That is one hour. That is too much pain. The folks on CNBC were in an absolute panic. How else are we going to show those on Main Street that we are doing a great job?"

Timothy Geithner: "You are doing a great job, sir. If you hadn't spent trillions of dollars, you wouldn't have saved the economy."

President Obama: "That's true Timmy (as he looked at the upward sloping curve on the figure in front of him). I did save the economy. Ben, what do you think we should do?"

Fed Chairman Bernanke: "Drop dollars from helicopters? It has worked before"

Larry Summers: "Been there, done that."

Fed Chairman Bernanke: "I got it. We will call out the air force this time to do the job. We can deliver more money a whole lot quicker. We don't need those army helicopters anyway."

President Obama: "Great idea, Ben. I have been trying to figure out a way to use the military. The air force is always so efficient, and using the military during a crisis is always a good way to bring out patriotism. Someone call the air force, please."

And with that the meeting was adjourned. Mr. Geithner went back to hitting the buy button. Mr. Bernanke went back to his offices to figure out more ways how he can say that America supports the Dollar. Mr. Summers waited in the wings hoping it will be his turn soon to be in control of the buy button.

President Obama strolled back into the oval office confident in knowing that he was at the center of creating America's new found prosperity. That's what the economic charts told him anyway.

The Greats Of The Blues: Freddy King

Freddy King, known as "The Texas Cannonball", was one of the most influential yet unknown blues artists of the 1960's and early 1970's. Unfortunately, he died at the age of 42 of heart failure. King inspired many young white guitarists around the world including Eric Clapton and Peter Green (Fleetwood Mac).

King's record "Let's Hide Away And Dance Away With Freddy King" (1961) is an instrumental classic that every guitar player should aspire to.

To learn more about Freddy King you can check out this biography at Wikipedia.

King's vocals were booming and his guitar style was original, and this can be easily appreciated in these two videos. In my opinion, one video cannot do justice to Freddy King.

Freddy King plays "Hide Away".

Freddy King plays "Big Legged Woman".

Rydex Market Timers: All In (Again!)

The Rydex market timers are all in again.

The last time I used those words was on September 25, which marked a short term high in the S&P500. About a week later, a reasonable short term (trading) opportunity developed.

Figure 1 is a daily chart of the S&P500 with the amount of assets in the Rydex Money Market Fund in the lower panel. When the money market fund is flush with cash, one can assume that the Rydex timers (like market participants in general) are fearful of market losses. From a contrarian perspective, these are good buying opportunities. When the amount of assets are low (like now), these market timers are all in; one should be on the lookout for market tops. There is little buying power left. As of Friday's close, the amount of assets in the Money Market Fund was at its lowest value since the bull run began in March, 2009.

Figure 1. S&P500 v. Rydex Money Market/ daily

The amount of assets in the Rydex Money Market Fund have been moving with in a range since early June, 2009. This range can be appreciated in figure 1. The three prior short term tops in this rally are noted by the yellow vertical lines. Coincidentally (sic), these short term tops had the Rydex market timers betting the wrong way.

Every now and then this sentiment thing works - until it doesn't. But remember, I cannot predict the next card out of the deck; I can only determine the best times to play.

Investor Sentiment: Consistency And Credibility

This week's comments are about why I continue to present the same data on investor sentiment week after week. Some readers have suggested that this data has been of little value during this historic bull run, and so why keep showing it. I believe the data has been relevant, but for those who see otherwise, let's just agree to disagree for now.

Of course, I would like to be right every time I put my thoughts and observations out to the world wide web, but I know that in this game of investing and trading getting it right all the time is impossible. However, I can be consistent in my approach, and this is what I strive to do. Consistency of approach plus getting a few "calls" right equals credibility. And credibility is very important.

So what prompted me to write about this today? It was this email from a reader:

"Your frequently, much touted 'smart money - dumb money' indicator must be causing you acute embarrassment because it has shown no predictive capability during this bear market rally. Just when one requires the indicator to deliver the goods and divine the market it fails miserably.

Do you ever regret making such a chump of yourself so publicly? :-)"

Now I don't like emails like this because well, they are down right nasty. But after writing on the web for over 5 years now, you develop a thick skin. You take the good with the bad. It is mostly good, and that is why I continue to do this.

So let's set the record straight about the sentiment indicators presented week after week in these articles. The "Dumb Money" indicator gave a bull signal in early March, 2009. This is why I wrote the following two articles on March 8: "Investor Sentiment: Bullish Signals" and "Putting A Bullish Signal In Context". On April 19, I suggested that it was "Time To Sell Strength And Tighten Up Stops". This really wasn't a bad call either because for the next 10 weeks the S&P500 actually went nowhere. The "Dumb Money" indicator showed that there were too many bulls in early May, and that is why I reminded everyone with the article written May 10: "Investor Sentiment: It Takes Bulls To Make A Bull Market". In this article, I discussed those rare times (i.e., less than 15% of the signals) when too many bulls is associated with a bull market. Hey it happens; we know it happens and you just have to understand when it is happening. Since early August, the extreme bullish readings in the "Dumb Money" indicator have been associated with a market that has an upward bias. And for the next two months in every weekly sentiment commentary I have stated the following: "There is an upward bias until the extremes in bullish sentiment are unwound, and there will be a bid under the market, and it will be tough to short or bet against this market for the foreseeable future." I don't know how I could have described this any more clearly or frequently. Now in the last three weeks, I have changed my tune, and I am suggesting that "equities are for renting not owning at this juncture, and that there is probably greater risk of a market down draft now than in past weeks."

My comments are not the result of some fantasy, but based upon the indicators themselves and grounded in the data. For the most part, I believe they have been accurate. The problem is that no one I know of or no indicator existed back on March 9 that would have predicted that the S&P500 would have moved up over 60% in 7 months. No one and no indicator!

But this is my proprietary "Dumb Money" indicator, and let's just assume for the sake of argument that it is lousy, and we should abandon sentiment analysis altogether. Ok, then what would you tell all those CEO's and company insiders who have been selling their stock in record numbers over the past quarter? Would you call them a "dumby head" too? Remember, I don't make that data up, I just report it. Oh, by the way, the buy and sell signals from the insider buying and selling data are fairly correlated with the buy and sell signals seen with the "Dumb Money" indicator. It is just another point of light shed on this complicated puzzle called market sentiment.

In the final analysis, I still think the indicators are valid, and they will continue to have validity along as there is fear and greed in the markets.

For me, the purpose of presenting the same data week in and week out is to demonstrate consistency in my approach. My view of investing isn't to be right every time because that is unattainable. I am looking to find and quantify an edge, and I believe sentiment provides such an edge. Once an edge is found, I want to execute on that edge in a disciplined manner.

Think of card counting in black jack. When the deck is in your favor, you want to bet heavy. When the deck is not in your favor, you bet light. A favorable deck says nothing about the next cards coming out of the deck, and a favorable deck does not guarantee a winning hand. However, over time by betting heavy when there is a favorable deck (i.e., your edge), you are skewing the odds in your favor that you will walk away from the table a winner.

So do I feel embarrassed? Or am I a chump? Of course not, and it never really crossed my mind. I do wish I had some holy grail indicator that tells me to buy here and sell here and nails the lows and highs every time. But that indicator doesn't exist, and it is someone else's fantasy. From my perspective, I believe in the data being presented. I will continue to show that data, and I will continue to make data driven observations on the market. I will remain consistent, and I hope this process creates credibility with my readers. This and a few good "calls" along the way.

Now on to this week's data, which is consistently like last week's data.

The "Dumb Money" indicator, which is shown in figure 1, 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. The "Dumb Money" indicator shows that investors are extremely bullish.

Figure 1. "Dumb Money" Indicator/ weekly

The "Smart Money" indicator is shown in figure 2. 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 2. "Smart Money" Indicator/ weekly

Company insiders continue to sell shares to an extreme degree although selling has moderated due to earnings season. See figure 3, a weekly chart of the S&P500 with the Insider Score "entire market" value in the lower panel.

Figure 3. InsiderScore Entire Market/ weekly

Figure 4 is a daily chart of the S&P500 with the amount of assets in the Rydex 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. Typically, we want to bet against the Rydex market timer even though they only represent a small sample of the overall market. As of Friday's close, the assets in the bullish and leveraged funds were greater than the bearish and leveraged by 1.91 to 1; referring to figure 4, this would put the green line greater than red line. When this ratio is greater than 2 the rally has generally stalled as noted by the maroon vertical lines.

Figure 4. Rydex Bullish and Leveraged v. Bearish and Leveraged/ daily