Posts tagged ‘AAII’
How is it that the stock market has more than doubled over the last three years, when investors have been dumping stocks like they are going out of style? If you don’t believe me, and you think jovial investors are jacking stocks higher, then please explain to me why billions of dollars are hemorrhaging out of equity funds on a monthly basis over the last five years (see Fund Flow data chart below)?
If by small chance you buy my argument that skeptical investors continue to doubt the sustainability of the three-year doubling in the stock market, then why is the Volatility Index (VIX) trading like investors are sunbathing at the beach while licking lollipops? For those not keeping score on the VIX (see also The VIX and the Rule of 16), typically a reading below 20 is interpreted as investor overconfidence and/or complacency. On the flip side, readings above 20 usually indicate pessimism or fear.
As you can see from the chart below, we have spent a good portion of the last few years on both sides of the 20 mph VIX speed limit, and currently at a reading of about 17, investors have slowed down to enjoy the scenery.
So with massive selling and a cheery reading on the VIX, how can these bipolar data-points be reconciled? Therein lies the “Fund Flows Paradox.”
Take Me Out to the Ballgame
If you equate equity investors to fans at a baseball stadium, the fund flow data clearly shows investors are tired of losing money and have been leaving the game in droves. Instead of staying at the equity baseball stadium, those fatigued stock investors have decided to head over to the adjacent bond arena. The equity stadium will never completely be empty because financial markets always have speculative traders. In baseball terms you can think of these short-term traders as the emotionally volatile die-hard fanatics, who will stick around regardless of whether the home team wins or loses.
So while sentiment gauges like the VIX, or sentiment surveys conducted by AAII (American Association of Individual Investors) may be temporarily flashing contrarian bearish signals, one should be cognizant that these data points do not include the petrified opinions of investors who have raced out of the stadium. Eventually when the home team’s winning streak is long enough, investors will return back to the stadium from the bond arena. While there is no sign of individual investors coming back to the stock game anytime soon, in the meantime patient and disciplined investors have had plenty of opportunities to take advantage of. With massive numbers of individual investors and sellers sitting on the sidelines, the markets require relatively little buying to push prices higher.
Over the last few years, not only have equity valuations been broadly reasonable, volatility spikes during the last few summers have also created amplified opportunities. With the wall of worries currently blanketing traditional and new media headlines (i.e., European crisis, U.S. election uncertainty, unsustainable and slowing profits, pending tax cut expirations, Mideast turmoil, etc.) there is no sense of urgency to pile back in to the equity markets.
The doubling in stock prices have occurred on low volumes, largely on the backs of a smaller institutional investor base, not to mention high frequency traders and speculators. While sentiment surveys may currently provide some insight into short-term equity trader attitudes, don’t let these volatile and unreliable data cloud the true underlying pessimism of the masses who have left the stock stadium in large numbers. Trillions of dollars remain on the sidelines as potential fuel for future equity appreciation, once confidence returns.
Opinions are interesting, but actions speak louder than words. Spend more time looking at the actions of the fund flow data, rather than the opinions of various short-term sentiment surveys or short-term options trader statistics. Adjusting your focus to investor actions and behavior will provide a truer gauge of overall investor sentiment and assist you in solving the “Fund Flows Paradox.”
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in VXX, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
The equity markets have been on a volatility rollercoaster while participants continue to search for the Holy Grail of indicators - in hopes of determining whether the next large move in the markets is upwards or downwards. Although markets may be efficient in the long-run (see Crisis Black Eye), in the short-run, financial markets are hostage to fear and greed, and these emotions have been on full display. In the last two weeks alone, we have witnessed the Dow Jones Industrial Average catapult skyward over +1,200 points, while just a few weeks earlier the Dow cratered about -800 points in a five day period. With fresh fears of a European banking collapse, a global recession, and an uncertain election in the U.S. approaching, investors are grasping for clues as they read the indicator tea leaves to better position their portfolios. Some of these contrarian sentiment indicators can be helpful to your portfolio, if used properly, however interpreting many of the sentiment indicators is as useful as reading tea leaves is for picking winning lotto numbers.
The Art of Tea Leave Reading
The premise behind contrarian investing is fairly simple – if you follow the herd, you will be led to the slaughterhouse. There is a tendency for investors to succumb to short-termism and act on their emotions rather than reason. The pendulum of investment emotions continually swings back and forth between fear and greed, and many of these indicators are designed with the goal of capturing emotion extremes.
The concept of mass hysteria is nothing new. Back in 1841, Charles Mackay published a book entitled, Extraordinary Popular Delusions and the Madness of Crowds, in which Mackay explores the psychology of crowds and mass mania through centuries of history, including the infamous Dutch Tulip Mania of the early 1600s (see Soros Super Bubble).
Out of sympathy for your eyeballs, I will not conduct an in-depth review of all the contrarian indicators, but here is brief sampling:
Sentiment Surveys: The American Association of Individual Investors (AAII) releases weekly survey results from its membership. With the recent stock market bounce, bullish sentiment has escalated up near historic averages (39.8% bullish), yet the bears still remain skeptical – more than 6% higher than normal (36.4% bearish). A different survey, conducted by Investors Intelligence, called the Advisors Sentiment Index, surveys authors of various stock advice newsletters. The index showed bearish sentiment reaching 46.3%, the highest negative reading since the 2008-2009 bear market low. These data can provide some insights, but as you can probably gather, these surveys are also very subjective and often conflicting.
Put-Call Ratio: This is a widely used ratio that measures the trading volume of bearish put options to bullish call options and is used to gauge the overall mood of the market. When investors are fearful and believe prices will go lower, the ratio of puts to calls escalates. At historically high levels (see chart below), this ratio usually indicates a bottoming process in the market.
Volatility Index (VIX): The VIX indicator or “Fear Gauge” calculates inputs from various call and put options to create an approximation of the S&P 500 index implied volatility for the next 30 days. Put simply, when fear is high, the price of insurance catapults upwards and the VIX moves higher. Over the last 25 years a VIX reading of 44 or higher has only been reached nine times (source: Don Hays), so as you can see from the chart below, the recent market rally has coincided with the short-term peak in the VIX.
Strategist Sentiment: If you’re looking for a contrarian call to payoff, I wouldn’t hold your breath by waiting for bearish strategist sentiment to kick-in. Barry Ritholtz at the Big Picture got it right when he summarized Barron’s bullish strategist outlook by saying, “File this one under Duh!” Like most Wall Street and asset management firms, strategists have an inherent conflict of interest to provide a rosy outlook. For what it’s worth, the market is up slightly since the Barron’s strategist outlook was published last month.
Short Interest: The higher the amount of shares shorted, the larger the pent-up demand to buy shares becomes in the future. Extremely high levels of short interest tend to coincide with price bottoms because as prices begin to move higher, holders of short positions often feel “squeezed” to buy shares and push prices higher. According to SmartMoney.com, hedge fund managers own the lowest percentage of stocks (45%) since March 2009 market price bottom. Research from Data Explorer also suggests that sentiment is severely negative – the highest short interest level experienced since mid-2009.
Fund Flow Data: The direction of investment dollars flowing in and out of mutual funds can provide some perspective on the psychology of the masses. Recent data coming from the Investment Company Institute (ICI) shows that -$63.6 billion has flowed out of all equity funds in 2011, while +$81.7 billion has flowed into bond funds. Suffice it to say, investor nervousness has made stocks as about as popular as the approval ratings of Congress.
When it comes to sentiment indicators, I believe actions speak much louder than words. To the extent I actually do track some of these indicators, I pay much less attention to those indicators based on opinions, surveys, and technical analysis data (see Astrology or Lob Wedge). Most of my concentration is centered on those indicators explaining actual measurable investor behavior (i.e., Put-Call, VIX, Short Interest, Fund Flow, and other action-oriented trading metrics).
As we know from filtering through the avalanche of daily news data, the world can obviously become a much worse place (i.e., Greece, eurozone collapse, double-dip, inflation, banking collapse, muni defaults, widening CDS spreads, etc,). If you believe the world is on the cusp of ending and/or you do not believe investors are sufficiently bearish, I encourage you to build your bunker stuffed with gold, and/or join the nearest local Occupy Wall Street chapter. If, however, you are looking to sharpen the returns on your portfolio and are thirsty for some emotional answers, pour yourself a cup of tea and pore over some sentiment indicators.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in JPM, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Market commentators and TV pundits are constantly debating whether the market is overbought or oversold. Quantitative measures, often based on valuation measures, are used to support either case. But the debate doesn’t stop there. As a backup, reading the emotional tea leaves of investor attitudes is relied upon as a fortune telling stock market ritual (see alsoTechnical Analysis article). Generally these tools are used on a contrarian basis when deciding about purchase or sale timing. The train of thought follows excessive optimism is tied to being fully invested, therefore the belief is only one future direction left…down. The thought process is also believed to work in reverse.
Actions Louder Than Words
When it comes to investing, I believe actions speak louder than words. For example, words answered in a subjective survey mean much less to me in gauging optimism or pessimism than what investors are really doing with their cool, hard cash. Asset flow data indicates where money is in fact going. Currently the vast majority of money is going into bonds, meaning the public hates stocks. That’s fine, because without pessimism, there would be fewer opportunities.
Most sentiment indicators are an unscientific cobbling of mood surveys designed to check the pulse of investors. How is the data used? As mentioned above, the sentiment indicators are commonly used as a contrarian tool…meaning: sell the market when the mood is hot and buy the market when it is cold.
Here are some of the more popular sentiment indicators:
1) Sentiment Surveys (AAII/NAAIM/Advisors): Each measures different bullish/bearish opinions regarding the stock market.
2) CBOE Volatility Index (VIX): The “fear gauge” developed using implied option volatility (read also VIX article).
3) Breadth Indicators (including Advanced-Decline and High-Low Ratios): Used as measurement device to identify extreme points in a market cycle.
4) NYSE Bullish Percentage: Calculates the percentage of bullish stock price patterns and used as a contrarian indicator.
5) NYSE 50-Day and 200-Day Moving Average: Another technical price indicator that is used to determine overbought and oversold price conditions.
6) Put/Call Ratio: The number of puts purchased relative to calls is used by some to measure the relative optimism/pessimism of investors.
7) Breadth Indicators: Measures the number of up stocks vs. down stocks.
8) Volume Spikes: Optimistic or pessimistic traders will transact more shares, therefore sentiment can be gauged by tracking volume metrics versus historical averages.
From a ten thousand foot level, the contrarian premise of sentiment indicators makes sense, if you believe as Warren Buffett does that it is beneficial to buy fear and sell greed. However, many of these indicators are more akin to reading tea leaves, than utilizing a scientific tool. Investors enjoy black and white simplicity, but regrettably the world and the stock market come in many shades of gray. Even if you believe mood can be accurately measured, that doesn’t account for the ever-changing state of human temperament. For instance, in a restaurant setting, my wife will change her menu choice four times before the waiter/waitress takes her order. Investor sentiment can be just as fickle depending on the Dubai, Greece, Swine Flu, or foreclosure headline du jour.
Other major problems with these indicators are time horizon and degree of imbalance. Yeah, an index or stock may be oversold, but by how much and over what timeframe? Perhaps a security is oversold on an intraday chart, but dramatically overbought on a monthly basis? Then what?
The sentiment indicators can also become distorted by a changing survey population. Average investors have fled the equity markets and have followed the pied piper Bill Gross to fixed income nirvana. What we have left are a lot of unstable high frequency traders who often change opinions in a matter of seconds. These loose hands are likely to warp the sentiment indicator results.
Investors are strange and unique animals that continually react to economic noise and emotional headlines in the financial markets. Despite the infinitely complex world we live in, people and investors use everything available at their disposal in an attempt to make sense of our endlessly random financial markets. One day interest rate declines are said to be the cause of market declines because of interest rate concerns. The next day, interest rate declines due to “quantitative easing” comments by Federal Reserve Chairman Ben Bernanke are attributed to the rise in stock prices. So, which one is it? Are rate declines positive or negative for the market?
On a daily basis, the media outlets are arrogant enough to act like they have all the answers to any price movement, rather than chalking up the true reason to random market volatility, sensationalistic noise, or simply more sellers than buyers. Virtually any news event will be handicapped for its market impact. If Ben Bernanke farts, people want to know what he ate and what impact it will have on Fed policy.
Sentiment indicators are some of the many tools used by professionals and non-professionals alike. While these indicators pose some usefulness, overreliance on reading these sentiment tea leaves could prove hazardous to your fortune telling future.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.