Equities: Sentiment Overview - Part I

Note: First of all, I want to say that I have received a lot of emails in regards to what sentiment indicators are saying and if we have bottomed in the stock market. So instead of answering each one of them individually, I thought it might be better for me to cover all the topics over the coming days with a sentiment and breadth two part write up. Second of all, some have even questioned why I am not as optimistic on stocks, as my last article was called Stocks: Crisis Still To Come. Basically, I cannot just pay attention to indicators, but also real world events. One of these real world events - away from the technical side of the market - would be a crisis default event in EU. Another would be the Chinese property crash.

Sentiment is extremely negative - that is for sure - so some of you will definitely be inclined to buy here. I cannot offer any advice other than the following: personally, I will not be buying any stocks myself just yet. I plan to open some positions on Agricultural commodities very shortly instead. But since majority seem to be more interested in equities, despite knowing that we are still in a secular long term bear market, I will cover the equity market indicators. One thing I can say is that if I had to choose between equities, bonds or cash - I would choose to buy equities as of today. Finally, Part I will cover sentiment and Part II will cover breadth (later in the week). There are a lot of indicators to get through so lets start...

Volatility Index

The VIX measures the implied volatility of near term at the money S&P 500 options. VIX will typically rise when the market drops and fall when the market rises, and while this is not always the case the correlation is clear - high volatility signals that a bottom is near. Currently the VIX has been trading above 30 for over two straight months and above 40 on and off for about a month and half. Previous spikes indicate that this type of volatility is not sustainable. From a contrarian point of view, this is the first indicator that is signalling a wash out and a buying opportunity - at least for a strong multi-month rally.

Sentiment Surveys

The Advisor & Investor sentiment is a model consisting of readings from several popular investment surveys. The components of the indicator, thanks to SentimenTrader, are the four most-popular surveys - Investor Intelligence, AAII, Market Vane and Consensus. I have placed a three month moving average on the readings to make sure signals can be trusted a lot more. Currently, we have just entered a buy signal territory, but that does not mean sentiment can't remain bearish for even longer, just like it did in 2002 or 2008. So be careful here.

The Investor Intelligence sentiment survey is conducted weekly and the bearish reading of the survey is one of the indicators I give most attention. The survey is based on 140 advisors aka "market pros" and their stance on the market, which can be either bullish, bearish or neutral. Two weeks ago, this reading hit just shy of 41% bears. This is the most bearish reading since March 2009. What does that mean?

According to my own statistical data study, which dates back to the 1980s, bearish readings of 40% or higher usually lead to gains of between 4% to 8% on average, three to six months from now. This indicates a good probability of a decently strong rally. Other studies show a similar picture. For example, dating back to the start of the Investor Intelligence data in 1969, a reading of 40% bears or higher returns on average:

• 5.1% six months from now and positive 68% of the time;
• 16.4% one year from now and positive 82% of the time;
• 31.0% two years from now and positive 94% of the time.

An old proverb says that that in one's blindness, one can mistake a few trees for a whole forest. I am referring to super bearish market analysts, who down-play the state of the current negative sentiment. They say that things can and will get much worse. They say VIX will spike to a million and sentiment surveys will make new record lows, never ever seen before. I would say have a beer, buddy. I do agree that "anything" can happen, but markets are a probability play and right now probability is in the bulls favour. Consider the following:

Jonathan Wilmot is a managing director and chief strategist at Credit Suisse who is a great investor and a pure contrarian. He has developed his own sentiment indicator through his career and currently this little beauty is signalling the worst ever bearish readings since the early 1980s.

Mark Hulbert is another great contrarian analyst that I respect very much and read all the time. He also runs his own sentiment surveys for stocks, bonds and gold, that tracks the performance of hundreds of investment newsletters. His team monitors these "market pros" on daily basis to figure out who is bullish, bearish or neutral; and also what kind of exposure they recommend for their clients.

As of 23rd of September, the Hulbert Stock Sentiment showed readings of -12%. That means "market pros", who get things wrong majority of the time (god bless them), are now recommending their clients to be -12% net short equities. Funny that, when in May 2011, these same "market pros" were recommending exposure of +67% net long. Other noticeable bottoms include July 2010, where the exposure recommendation was -16% net short and March 2009 at -20% net short.

Hedge Fund Performance

There is this myth within the market place that hedge funds are smart money. Yes, maybe 5% are, but 95% are as good at timing the market as any of the other "market pros" from the newsletter advisory side mentioned above (god bless them all). Therefore, I like to track hedge fund performance each month, as reported by the Hennessee Group.

The indicator in the chart above is solely my own, however I presume a lot of investors with common sense understand that forced liquidations by any "institutional money funds" is a great buying signal. My own indicator is basic, but not perfect. It states that large winning streaks by hedge funds usually lead to trouble, while heavy losses usually lead to opportunities. Currently, we have a buy signal in place, but that does not mean liquidation will stop right here right now.

One of my favourite indicators is in the chart above. It has less to do with who said what, where and when; and everything to do with who bought what, where and when. Therefore, one should pay close attention to it. From 1st of September to 8th September, Merrill Lynch Fund Managers Survey polled a total of 286 panelists with US$831 billion of assets under management. What was the result?

Investors held the most cash in three years this month amid the biggest equity sell-off since October 2008, a month after Lehman Brothers Holdings Inc. went bankrupt. Investors are also underweight equities and admit to having the shortest investment time horizon ever (since December 2001 when the survey started). We are now at the lowest level of risk appetite seen since March 2009. According to my own chart above, we now have a buy signal in place. Finally, where are investors fleeing to apart from cash? The survey says: Bonds.

Options Positioning

Most equity option contracts are bought to open, and not sold to open.Therefore, most of the volume represents purchases. Therefore, heavy volume in put contracts shows fear, while heavy call volume shows optimism. In the chart above, I have placed a 21 day (one trading month) moving average to filter through the noise. Compared to December 2010, where readings hit a bullish 0.51 ratio, today we have readings above 0.70s. Could things get worse, like in 2008, where investors bought even more puts? Sure they can. Having said that, a buy signal is given above 0.8 in this indicator, and that was reached around early August.

Corporate Insider Activity

The chart above is from the Technical Take blog. The basics of this indicator comes down to this: insider selling is not as important because insiders sell company stock for any number of reasons. However, insiders typically buy only because they believe their stock will rise. This is what we saw in the early part of August; while Dumb Money was buying puts and the rest of the headless chooks went on about a deflationary world end - Insiders went on a buying spree similar to that of November 2008 and March 2009. From my experience of following the markets, you can be contrarian against many different market participants, but you do not want to bet against these guys. When they buy en masse like they did in early August, they are hardly ever wrong. Last weeks InsiderScore report stated:

“Sentiment remained Neutral as the number of buyers fell -8% week-over-week and the number of sellers increased 29%. Buyers were still in the lead, outpacing sellers 6-to-5, but there was an obvious lack of conviction on both sides of the trade. As was the case the prior week, no sector or industry flashed a strong signal in either direction and though there was some actionable buying and selling on acompany-level, there was little common ground – outside of acautiously neutral play area – to be found amongst insiders. We should see a measurable decrease in insider trading volume this week as companies begin to close their trading windows and insiders start getting forced to the sidelines until after their companies ’respective earnings announcements. “

One could assume that insiders used the recent open window to buy a huge amount of stock during the sell of in August, prior to the reporting season. Do they know something we don't? Are earnings risks to the downside like many believe or could they now be to the upside? Follow the money I say!

Earnings Analysts

You probably should not believe a word these guys say majority of the time. I don't - that is for sure! They just yap and yap about how stocks are cheap, earnings are great and the future is always bright. They have ridiculous targets on stocks 365 days of the year. Having said that, most investors, fail to understand how to use this group of Wall Street "experts" to their advantage.

Majority of the time you should disregard any earnings talk these guys do. But, when they finally start capitulating on their perma bullish outlook, like we can see in the chart above, you should sit up and pay attention. That is usually when stocks start to bottom and this is usually a time when they have egg on their faces. Looking at the chart above, earnings revisions have fallen very dramatically in Europe and aren't too far away in US and Asia either. To a certain degree, pessimism is similar to the 2002 bear market, but not as bad as the thumping of a lifetime markets received in 2008.

In the US, commodity sectors like Materials and Energy have been beaten down in recent weeks. The question now is have these commodity stocks fully discounted a slowdown coming from Asia? I am not so sure about that and this is one of my main worries - disappointment in the Asian economies. Nonetheless, it seems that analysts are definitely capitulating in the commodity space.

Technical Analysts

Technical Analysts are just as bad as Earnings Analysts. However, at least they track the price, which is a leading indicator, instead of earnings or economy which tends to lag. The problem with technical analysis, in my opinion, is too many strategists try to predict things. Personally, I use technical charts to see what has happened as opposed to predicting what will happen. I use economic cycles and conditions for that and not charts.

Now, you must have seen a chart similar to the one above about a hundred times in the recent weeks. If you haven't, you must be living in a bear cave and have failed to come out. A few days ago on CNBC we had four technical analysts and all of them predicted we are going another 20% to 30% lower. If you are a bull, you have to feel good about that type of a thing, because these guys all herd and sound like parrots. Having said that, the basics of technicals in the chart above state that we haven't yet retraced 50% of the the last bull market since March 2009.

I personally think a test of 1040, which was last Augusts low before QE2, could mark a strong bottom and at least set us up for a powerful rally. New highs above 1370? I am not so sure about that, but I'll discuss that later. On the other hand, super bears think we are heading down to March 09 lows of 666 and then even lower in the coming months.

Equity Valuations

I don't really pay attention to forward P/E ratios. However, for those that do, here are some charts for regional equity indices. I do have to admit that if you believe earnings will not fall dramatically and the economy will not enter a recession this year, then valuations on forward basis "look" as cheap as March 2009. However, the key word here is "look"...

Personally, I prefer looking at long term valuations that tend to average a few cycles and remove the noise and volatility of earnings and price. As can bee seen in the chart above, these are Market Cap vs GDP, Q Ratio and CAPE 10. For me, equities remain in a secular bear market and from the valuations above, are just not cheap enough for a long term buy and hold - that is why I stick with commodities. Having said that, equities are much much cheaper than they were in 2000 and while valuations will adjust further to the downside, equities do not necessarily need to move down as well. They can move sideways like in the 1930s and 1970s. As a matter of fact, they can even adjust to the upside if money printing accelerates.

Fund Flows

I could make a fair argument from the chart above, which tracks ICI mutual fund flows against the S&P 500, that during this secular bear market in equities - which started in March 2000 - prices have pretty much gone sideways (nominally) and yet the sentiment has changed dramatically. Mums and dads aka retail investors are just not "feeling it" anymore and the whole buy and hold strategy that their financial planner told them to do in 1999 is now out of the window. They have been selling hard and fast since 2007. Unlike the huge monthly inflows during the Technology Bubble, today we see huge monthly outflows of the same amount. How times have changed...

Having said all that, usually when outflows reach $20 billion on a bi-monthly streak, like we saw in September 2001, October 2002, March 2008, October 2008, May 2010 and in the last few months - market gets ready to put in a bottom. Basically, as a contrarian, when retail investors "leave", you want to "arrive".

There are many different traders, investors, strategists, analysts and experts of skill within the market environment. It is a melting pot with the goal to make money. Keeping that in mind, if Corporate Insiders are one of the smartest groups out there, than Rydex traders have to be the complete opposite. If the English vocabulary failed to invent a word that was worse than “dumbest”, then Rydex traders would be the closest phrase available. These guys are hilariously wrong all the time. They are actually dumber than the dumbest - if that makes sense. Rydex traders, on averages, get all the bets wrong, all the time. The chart above, thanks to SentimenTrader, explains the rest. If you are feeling bullish... bet against these guys and you'll make money at least for a rally!

Of course, there are a few smart cookies between all of you now thinking... where has all this money gone, if it left the stock market? Great question. The answer is fixed income aka bonds. Mums and dads aka retail investors aka consensus aka dumb money (plus their Rydex friends), are now in agreement with deflationists that the best place to park your money is in bonds. Rydex traders are jumping over each other to buy some Treasuries. I am actually considering a short right here tonight! Remember Bob Farrell's Rule which states that the public buys the most at the top and sells the most at the bottom? Looks like the majority don't remember.

Annualised Returns

It seems that after a 30 year bond bull market, where yields have gone from 16% in 1981 to sub 2% in 2011, the public has been piling in en masse (as already discussed above). This is why I keep stating that in a choice between equities and bonds, equities will do better from here on out. If you clue your eyes 10 years from now, you will be in profits with stocks and totally ripped out with Bonds, sitting in an alley like a homeless person with Bernanke next to you. Also, remember that during the worst conditions of the Great Depression around 1937, when the deflation argument must have been in full force, was the actual bottom of equity underperformance relative to bonds. In other words, contrarians who bought equities when the news was awful got rewarded. Is this time around going to be different?

Seasonality

When the VIX index spikes, seasonality usually leads us to a final top around October. That would mean market indices could also place a bottom around October too. This is not a Golden Rule or a Holy Grail, but majority of the time bear markets or strong corrections do bottom into October. History proves this to be the case in 1957, 1966,1974, 1990 and 2002. Prior to WW2, there are also many examples, but you get the point: respect history and respect Octobers!

Summary
We have forced liquidating for Western Equities, Emerging Market Equities, Emerging Market Currencies, Industrial Commodities, Mining Companies, Agricultural Commodities, Energy Commodities, Commodity Currencies, Eastern European Currencies, High Yield Bonds, and anything else risky. On the other hand we have accumulation of US Dollars and Governments Bonds. However, contrarians should do the opposite for now, but it all comes down to a matter of timing. Note: I have to admit that I am one of those who plans to accumulate more US Dollars in due time.

Volatility has been high for months; sentiment surveys are extremely negative; hedge funds are losing money; institutional cash levels are high; dumb money is loading up on puts; insiders were buying heavily last month; analysts are now capitulating; valuations are attractive if you believe in Asian demand & growth; mums and dads exiting; Rydex dumb money is also panicking (god bless them); seasonal weakness is ending in October; and finally equities offer value against bonds and cash.

The bottom could either be here already for some sectors or coming sometime next month with a possible retest of the 1040 support for the whole index. But the question now is, are we going to rally from September / October to a new high above May 02nd at 1370 on the S&P 500? Or will Asian economies including China disappoint in 2012?