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Buzz & Banter


Below, Tony brings up two points, both dealing with market sentiment:

1. What are people DOING versus what they are SAYING?
2. Is the fact that seemingly everyone mentions sentiment likely to lessen its effectiveness? Does one now have to be contrarian about being contrarian?

As far as #1 goes, there are a number of ways to compare opinions versus real money. I shy away from anecdotal evidence, and here's why: Tony talked to his clients, and came away feeling that his clientele is not overly bullish. On the other hand, I talk to several (usually between 15-20) fund managers and even more (20-50) individual investors on a very regular basis. Out of all of those, I know of only one individual who thinks a crash is imminent. The overwhelming majority have the attitude of "sure, we might decline here for a few days, even a few weeks, but I'm looking to buy at the next oversold reading". That, to me, suggests a predominantly bullish outlook. I don't put much weight behind it, since there is no way I can test whether these individuals are usually right or wrong in their opinions, but it brings up the dangers of using anecdotal evidence - it depends on who you talk to, and the sample size is rarely, if ever, large enough to be meaningful.

The major sentiment polls (Investor's Intelligence, Market Vane, Consensus, AAII) are mostly at or near bullish extremes. For the most part, each of them relies on what people are saying, and not what they are doing. So, as Tony says, people say they are bullish. But where is their money going? Let's look at a few real-money measures:

• Put/call ratios - see the chart below in my previous post. Retail traders, most often wrong on market direction, have been trading call options heavily, and we're only just beginning to correct that. Put this one down as bearish for the market.
• Rydex asset flows - we saw incredible speculation in the asset shifts among the Rydex funds last week, which has begun to wear off in the past few days. Our longer-term measures here are relatively tame. This is neutral.
• Commitments of Traders - commercial traders remain modestly net short, while small speculators continue to hold a relatively large net long position. Moderately bearish.
• Short interest - even with the influx of convertible bond issuance over the past few months, short interest on the NYSE has declined for three out of the past four months, with August showing the largest one-month drop since 1999. This is unusual, since short interest goes up a majority of the time on a month-to-month basis. While I would not suggest short interest is now extremely low, it is certainly not what I would consider high, as it was at this time last year. Neutral to moderately bearish.

These measures, in my opinion, accurately reflect what the sentiment polls are suggesting - that investors are confident of rising prices. Are they "too" bullish overall? I think so, and it keeps me preferring the short side here for longer-term trades, but we are not at such extremes that I would immediately short a break of 1015 on the S&P 500. There is some wiggle room here, and I think a technical breakout could carry at least several percent.

As for point #2, I can't even recall how many times I've read the assertion that sentiment isn't going to be an effective indicator here because too many people know about it. The theory is that traders are too bearish because other traders (e.g. the sentiment polls) are too bullish. But I could just as easily assert that one SHOULD be bearish because everyone is bullish because everyone is bearish because everyone is bullish! I prefer to keep things simple, and not try to keep outguessing effective indicators. I have no idea if too many traders are now following sentiment. Perhaps they are, and sentiment as a discipline will gradually lose its effectiveness. But I remember the same things were said about put/call ratios when they became widely followed, and the VIX when it became available on every piece of quote software, yet those indicators continue to give some excellent heads-ups.

Historically, sentiment conditions like we've seen over the past several months have lead to weak equities. Perhaps this will fail as it did in May, and we'll see another leg higher. I'm not betting that way, but each of us must balance the three major engines of stock price movement (fundamentals, technicals and sentiment) and position ourselves accordingly.
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