Thursday, January 31, 2008

Tracking Confidence in Financial Stocks: Identifying Short-Term Sentiment

I interviewed with a reporter from a German language magazine recently, and he asked a good question: With all this volatility, how can a short-term trader know whether to be buying or selling? He observed that it seems as though the market is down sharply one day, up sharply the next, and then down again.

There are many short-term sentiment gauges that can be helpful to the intraday trader. These include equity put/call ratios and the TICK (number of stocks traded at the market offer minus the number of those traded at the market bid).

A different way of assessing sentiment, I explained to the reporter, is to gauge whether the market is trading in a confident or frightened mode. We can identify this, I suggested, by tracking the market's most vulnerable issues.

Above we have three stocks that have been quite vulnerable: MBIA (MBI), which is a major insurer of bonds; Citigroup (C), which is dealing with the credit crisis; and Federal National Mortgage (Fannie Mae; FNM), which is reeling from the housing crisis. The trajectories of these shares has been breathtaking to the downside. They are the equivalent of the tech stocks during the 2000-2002 bust.

We have been seeing aggressive steps from the government and central bank to address the economy overall and the concerns affecting these shares specifically. When the market feels confident, it expresses this confidence by picking up financial stocks such as these in hopes of finding bargains. When the market is fearful of credit-related collapse, it dumps these shares.

If we look at the movement in MBI, C, and FNM as a kind of sentiment gauge, we find that sentiment swings have become exaggerated in 2008 thus far. The average size of the daily price changes in MBI, C, and FNM during 2007 were 2.59%, 1.28%, and 1.98% respectively. During 2008, those average daily swings have averaged 11.99%, 2.56%, and 4.30% respectively. It's not just that traders and investors have become more bearish on these shares; the variability of their assessments of the companies has become more volatile. Manic-depressive might not be a bad term for current sentiment regarding these financial stocks.

Why does this matter? It is difficult to imagine sustaining a fresh bull market while investors nurse concerns over the financial system. During 2008 to date, the daily correlation of price changes between the stocks and the S&P 500 Index (SPY) has been:

MBI and SPY: .42
C and SPY: .91
FNM and SPY: .61

That is, when these stocks rise, it's likely that the overall large cap market is rising; when the fall, the entire market tends to be falling. Correlation does not equal causation, but when these financial shares are acting weak, it's generally been a good sign that the market overall is harboring concerns worthy of attention. That was most recently evident when MBI failed to confirm the overall market strength prior to and immediately following the Fed announcement yesterday.

And how about volatility? Here's the day-to-day correlations between the absolute size of daily price moves in MBI, C, and FNM with SPY for 2008 to date:

MBI and SPY: .36
C and SPY: .79
FNM and SPY: .36

In other words, when these financial shares are more volatile--one way of detecting the degree of manic-depression in sentiment--the market as a whole tends to be more volatile. Again, correlation is not causation. Rather, it suggests that variability of sentiment regarding these shares is closely aligned with variability of market sentiment overall.

By tracking strength and weakness in these and similar shares intraday, we can identify confidence and fear regarding the financial system--and especially track the ebbing and flowing of these emotions. Along with the shares of homebuilders and Treasury prices (which reflect flight to quality vs. risk seeking movement out of bonds), these are among the short-term sentiment gauges I'm currently finding most useful.