Mood Swings

I believe the most likely outcome for the coming week is a higher market but a bear case could be made as well. The market is now oversold as the S&P 500 is down 8 of the past 10 days. It seems that short sentiment has soured just as we reached this oversold reading. Anecdotally, I noticed traders were quite gloomy on Friday and the weekly poll shown below supports my suspicion. All this is supportive of  a rally this week, which is also the beginning of the month.

There is a bear case to be made as well. Despite the short term negativity, the intermediate term sentiment indicators are still close to excess optimism. The oversold reading is not great as many of the down days were only slightly down.  In recent years we have seen numerous instances where the market picks a direction and goes there in a straight line despite oversold or overbought readings.

I would much prefer it if the intermediate term sentiment indicators were showing excess negativity instead of excess optimism. I would also prefer a better oversold reading.  Still, I believe the odds favor a bounce in the coming week. As a result I am moderately long.

Looking For A Bounce

The S&P 500 has been down seven out of the last eight days and has more than erased the rally following the Fed announcement of QE Infinity. While I don't believe this is a great buying opportunity we should see some sort of a bounce in the next few days.

The reason I don't believe this is a great buying opportunity is because sentiment is still too bullish on an intermediate term basis. With that said its likely any further dips in the next couple of days could be bought for  a bounce. Once we get a bounce the market outlook becomes a lot murkier. We have seen in recent years sentiment stay extreme heading into year end numerous times. At the same time staying long when there is excess optimism is a dicey proposition. A further decline in October that sours sentiment would create a better opportunity into year end.

For my part I am moderately long. I was out of the office yesterday but stuck in a buy order on Tuesday to remove some hedges if we dipped further. That order was filled yesterday morning. I will look to use  a bounce in the coming days to reinstate those hedges.

Excess Bullishness

In the past I have compared stock market sentiment to a compass. Sentiment does not tell you precisely where you are in a rally or a decline but it helps you get your bearings. Excessive optimism tends to occur in the latter parts of a rally and most indicators are pointing towards excessive optimism.

Last week I pointed to some signs that the crowd may have turned excessively bullish and  since then some more signs have piled up.

  • Market Vane bulls are the highest since June 2007.

  • The NAAIM survey of manager sentiment is above 80, which has been about as high as it gets.

  • The 10 day moving average of the CBOE put/call ratio is the lowest its been in one and a half years.

  • I spent quite a bit of time this past week listening to Bloomberg radio and there was not a single bear.

The vast majority of sentiment indicators are now pointing to excessive optimism. The anecdotal evidence I am seeing is pointing to excessive optimism.  While these periods of excessive bullishness tend to last longer than they used to, they still do not tend to end well.

A Change Of Heart Towards Yahoo!

In February I considered an investment  in Yahoo! but ultimately decided against it. I believed that too much Yahoo's value was tied up in their Asian assets. I did not trust Jack Ma, Chairman and CEO of Alibaba, to follow through on a deal due to his shady history. A deal has now closed and Yahoo! has successfully sold half its stake in Alibaba and will likely sell the other half in an IPO. Yahoo is in negotiations to sell their stake in Yahoo! Japan as well.

Now that Yahoo is well on its way to monetizing its Asian assets I am willing to give them credit for these assets. Excluding cash and Asian assets Yahoo sells for 0.6 times estimated 2013 EBITDA. As a comparison AOL sells for over 4 times EBITDA. Regardless of what one thinks of the business the price is  extremely low.

There is a catalyst in place for higher prices. Yahoo! will return $3 billion to shareholders in the near future. There should be an announcement shortly as to how they will do this. I suspect at the current price they will opt for a share repurchase or a tender offer although a dividend could be involved as well. I am long shares of Yahoo!

They Are Bullish

There are an increasing number of sentiment indicators that are pointing to high levels of bullishness:

  • The amount of money in bullish Rydex funds versus bearish is within spitting distance of an all time record.

  • Hulbert Nasdaq market timers are recommending a 64.7% net long. They have gotten as high as the mid to high 70's but is clearly in the high end of bullishness

  • Last week we had a 52 week high in call buying at both the ISE and CBOE

  • The Investors Intelligence bulls are above 54%, which is approaching the danger zone. Unfortunately the bears are still above 24%. The best signal is when the bears are below 20%.

We have seen numerous rallies in recent years where the extreme bullishness did not matter for a long time. However, eventually the extreme bullishness did matter and all the gains were subsequently taken away. If we are not in extreme bullish territory than we are on the precipice.

Repeating The Same Mistakes

I find it shocking that after a four year malaise caused by a housing and credit bubble the Fed is trying to reinflate the same bubble. Unfortunately, the end result will likely be the same and perhaps worse. The situation depresses me but as an investor I must put this aside and play the hand that I'm dealt.

In the short run the market is getting quite frothy and I am expecting a pullback to start in the next few days. I expect that this pullback will likely be bought and that the market will climb from there. I will likely buy into that pullback and allow myself to be about 50% net long with very conservative, cheap, low beta names.

I have not yet decided if I will attempt to play the coming pullback I envision. I am leaning towards not because I will be out Monday and Tuesday of next week. Once we get a pullback I will likely hold my nose and buy.


According to an email sent out by Morgan Stanley to clients, their hedge fund clients went from a 43% net long posture last Wednesday to a 47% net long posture Friday. This was after they had been 40% net long on average for the past three months. This email highlights the dynamic at play. The higher the market goes, the more pressure there is to get invested.

Mutual funds and ETFs basically stay invested at all times but hedge funds have huge swings in exposure. These huge swings in hedge fund exposures tend to exacerbate a trend. While few hedge funds would admit to being momentum vehicles, as a group they act much like one would expect a momentum vehicle to act. This leads to seemingly endless rallies and endless declines.

One must respect the possibility of further upside as we have certainly seen examples of such situations in recent years where a market refuses to rest. With that said, I believe we are at a high risk point for some sort of a pullback/correction. It seems to me the bears have given up and everybody is certain QE will take us up forever. Im not so sure but not brave enough to do much about it except stay defensive.

Topping Out

I covered my SPY short that I initiated yesterday morning at the close. I remain defensively positioned. Topping is a process where we often see multiple attempts at the highs before the market finally gives way. The reason being that those who were under invested for the rally use the dips to increase their positions.

The large AIG offering was a good opportunity to take a  stab at the short side. I will be relying on my sentiment indicators to guide me as to when there is excess bullishness. This may lead me to take more stabs at the short side in the next couple of weeks. There was a good amount of call buying yesterday despite the down day. I suspect we are in the excess optimism stage of the rally and are topping out but will wait until I see the white if the bull's eyes before making more short side attempts.

Incoming Supply

The treasury is selling at least $13 billion worth of AIG shares to the public this week while insiders at Michael Kors are selling over $1 billion of shares. It is possible that the secondary calendar approaches $20 billion this week, which is a number not seen very often. I believe the market will have  a tough time digesting that much stock and continuing higher. At best I see the market treading water.

As a result of the heavy secondary issuance calendar I decided to short SPY in the pre-market and move to a roughly market neutral stance from an already defensive stance. I was originally planning on waiting for  the sentiment indicators to confirm my suspicion that market participants are excessively bullish. However, with this much supply the short term upside should be limited regardless.


The Scenario

The scenario I laid out where we get a breakout of the range and sentiment turns excessively optimistic seems to be occurring. This will likely take some time as tops are generally processes. I want to see my sentiment indicators confirm my suspicions but the early indicators are pointing to excessive optimism.

At Rydex there is more than 5 times as much money in bullish funds as in bearish funds. That is close to an all time high. We are also seeing some extreme readings in option indicators, with the ISE equity closing yesterday at 215. I will be looking for confirmation from the sentiment surveys in the coming week.

I am not interested in catching the last few percent of a rally. That is where I believe we are. There should be better chances to buy stocks even if we go a little higher first. Have  a great weekend.

The Hedge Fund Blues

According to Hedge Fund Research the average hedge fund returned 0.5% in August, while the S&P 500 returned 2.3% and the Russell 2000 returned 3.3%. It is difficult to conclude that hedge funds have high stock market exposure given the amount they lagged the major indices in August. Hedge funds can ill afford to continue to miss the rally as they are lagging the S&P 500 for the year by  a wide margin. For the year the average hedge fund is up 2.23% through August while the S&P 500 is up over 13%.

The sentiment indicators I follow are just shy of extreme bullishness. One last rally that sucks in the hedge funds and pushes the sentiment indicators into extreme territory would likely lead to a meaty correction. However, if the market declines now hedge funds would likely use the weakness to increase their exposure and I don't believe it would go very far.

There is an undeniable profit slowdown occurring as we are seeing profit warnings on a daily basis, with Fedex being the latest. With valuations being in the realm of normal and the possibility a profit slowdown the risk/reward in the market does not seem great. I continue to wait for market participants to push this market to one extreme or another before I take a strong stance.