Saturday, March 03, 2007

Subprime Sentiment: When Money is Fleeing Stocks

Recently I've been posting data concerning the Relative Dollar Volume Flows into and out of the Dow stocks. The flow data have been helpful in determining which stocks are hot and which are not. This is because the data reflects the sentiment of the largest participants in the market: the Relative Dollar Volume Flows increase when large trades are executed at the market offer and decrease when large trades are consummated at the bid. Because markets typically spend more time going up than down--bull markets and swings last longer than bear ones--it is typical for the flow data to have a positive bias. During falling markets, such as the one we've seen this past week, Dollar Volume Flows for the Dow 30 issues fall well below their average, but remain net positive.

What that means is that it is rare to see persistently negative flows. This would be equivalent, in intraday trading terms, to seeing NYSE TICK readings that are persistently negative on the day. Such readings can only occur when large participants are bailing out of the market en masse. Tuesday's market plunge, in which NYSE TICK readings were frequently outright negative--not just below their positive average--was a good example of such extreme negative sentiment.

A good example of this dynamic was the 2000-2002 market decline. Relative dollar flows for the Dow 30 stocks as a whole dropped significantly, but only occasionally turned outright negative. The dollar flows for many NYSE and NASDAQ technology issues, however, were persistently negative. Real money was flowing out of that sector, and it showed up in a significant market decline. When sentiment, as revealed by the actual buying and selling actions of large market participants, turns decisively negative, there's usually a story there. Large traders aren't going to exit at the market bid and give up the edge unless they really want to get out of the market. Again, just think of Tuesday's debacle.

At present, among the Dow stocks, MSFT is the poster child for persistent negative sentiment. As I noted in today's installment of the Trading Psychology Weblog, MSFT has registered outright negative Dollar Volume Flow for 16 of the past 20 trading sessions. Again, we can see that, where large traders and investors are bailing out of a stock, there's a story to be found. In the case of MSFT, Vista's woes are well chronicled in the tech community and in CEO Ballmer's recent comments. What the dollar volume flow data tell us is that investors are truly acting upon these concerns.

Seeing how radically different MSFT's dollar volume flows have been compared to other Dow issues, I decided to go on a hunt for other stocks with outright negative readings on a persistent basis. That brought me to two stocks with truly subprime sentiment: Goldman Sachs (GS) and Morgan Stanley (MS). Goldman has had net negative Dollar Volume Flows for 11 out of the last 20 trading sessions and 28 of the past 40. Morgan Stanley has registered outright negative Dollar Volume flows for 18 of the past 20 trading sessions. In other words, both have shown net dollar volume flow out of the stocks well prior to the recent market decline.

As this provocative report from Bloomberg indicates, there is indeed a story there. GS and MS are two of five investment banks that represent 86% of the credit default swap market, according to that story. Prices for these instruments have fallen to junk levels, suggesting that the banks' own traders are pricing in quite a bit of risk. Woes in the subprime mortgage market have been well chronicled in market blogs, including overviews from Barry Ritholtz and Michael Shedlock. With the fall in lending standards, the Fed has urged caution re: subprime mortgages. This raises concerns about the exposure of big investment banks to these subprime mortgage problems. We've seen dramatic price declines among the subprime lending firms themselves, as poor loan quality has caught up to them. The fear is that this could be the leading edge of a meltdown that affects the large banks and the entire economy.

The dollar volume flow figures tell us that large traders and investors in GS and MS are acting upon those concerns. Instead of using the recent market weakness to snap up bargain-priced shares, they have taken money out of GS for five of the last seven sessions and out of MS for six of the last seven. Overreaction? Perhaps. As the saying goes, however, if you can keep your head about you while everyone else is losing theirs, perhaps you're not aware of the situation.