A Study in Complacency
In late June we remarked on the astonishing degree of complacency in the stock market. Not so much, as we argued, complacency about the near term outlook for stocks, but about the medium to longer term one.
Clearly, people are no longer as wildly bullish as they were in the vicinity of the February and April highs. In late 2010, as well as near the February 2011 and April 2011 highs in the S&P 500 index, a number of rare extremes in bullish sentiment were in evidence, both in surveys and positioning indicators.
However, there was a noteworthy fragmentation in the data and moreover there has been a growing divergence between market prices and the accompanying sentiment highs.
Said 'fragmentation' refers to the fact that different sentiment indicators have produced highs in measured net bullishness at different points in time. As an example, the AAII survey of individual investors reached the highest level in net bullishness since early 2006 in late December 2010, whereas the Investor's Intelligence poll reached the highest reading in net bullishness since August 1987 in late March 2011, following the rebound from the sell-off occasioned by the tsunami in Japan.
The AAII sentiment poll of individual investors, via decisionpoint.com. The violet bars at the bottom show the ratio of bulls to bears. A multi-year high in this ratio was recorded in late 2010 (exactly 4 times as many bulls as bears) – click for higher resolution.
The Investor's Intelligence poll of investment advisors – the high point in the bull/bear ratio reached in late March of 2011 was the highest reading in net bullishness since the summer of 1987. What is significant is that it was recorded a full 3 ½ months after the high in the AAII bull/bear ratio – click for higher resolution.
The growing divergence between high points in bullish sentiment and highs in the S&P index is best illustrated by the cumulative cash flows into Rydex bullish index and sector funds depicted below. Rydex funds only represent a tiny slice of overall trading activity and with the advent of ETF's that allow people to replicate the Rydex bull/bear funds, their importance has decreased even further. And yet, in spite of its relative unimportance in the bigger picture, the Rydex microcosm still offers a statistically relevant glimpse into the evolution of market-wide sentiment. As such it remains a very useful indicator.
Cumulative net cash flows into Rydex bull and bullish sector funds. While the market made higher highs, the cumulative cash flows into Rydex bull funds made several consecutive lower highs. This is an important divergence – click for higher resolution.
A similar divergence between market prices and sentiment is in fact evident in nearly all sentiment indicators – most notably, the new high in the S&P 500 in April failed to be confirmed by new highs in net bullishness across the entire spectrum of these indicators. The 'Options Speculation Index' put together by sentimentrader.com depicted below (both decisionpoint and sentimentrader are excellent sites that we highly recommend to traders and investors for the wealth of useful data they offer) measures net bullishness in options positioning by totaling opening transactions from all US options exchanges combined. It compares all bullish transactions (call buying and put selling) with all bearish transactions (call selling and put buying). This indicator recorded a new high in bullish positioning in late 2010. This was a noteworthy extreme, exceeding the bullish consensus at the 2007 market high by a wide margin.
