The best sentiment indicator is one no one ever pays attention to.

It’s something we’ve come up with to get a snapshot of true market sentiment unbiased by the headlines, emotions, and any other factors that hamper your decision-making when the markets are falling.

The indicator which correctly indicated near-term bottoms in the fall of 2008 and March 2009 is based on the trading of closed-end funds (CEF).

You see, CEFs are like mutual funds but trade like stocks. The key difference is that mutual fund prices are based on net asset value (NAV) of all the funds’ holdings at the end of each trading day.

CEFs, on the other hand, are priced by the market. Their prices are determined by what an investor is willing to pay for the fund. The price normal hangs around the NAV of the fund, but it trades at either a discount or premium. The premiums are high when stocks are on the rise. Most trade at a discount when stocks are going down.

The CEF Indicator Nears “Buy” Range

Normally, 35% to 50% of CEFs carry a premium to NAV. But when fear is high, like during the credit crunch hit of2008 when overleveraged investors were forced to sell everything, CEFs were absolutely decimated.

In 5 Signs of a Market Bottom, published on October 28, 2008, we wrote:

Two weeks ago, when the markets seemed like they just couldn’t get any worse, only 18 of the 597 (just 3%) closed-end funds were fetching a premium.

That was the lowest number I have ever seen. The bearish sentiment in closed-end funds was peaking.

Now, 57 of the funds are trading at a premium. By historical standards, anywhere from 35% to 50% of them should be trading at a premium during a flat market. With only 9.5% of them trading at a premium to NAV, the markets are clearly overly bearish.

At the height of a panic, 3% of CEFs had a premium. As the “Obama-Rally” kicked off, 9.5% of them were trading at premiums to their NAV.

Now, after a long solid run for the markets and a recent turn for the worse, bearishness is starting to manifest itself in CEFs again.

As of today 22.9% of equity CEFs tracked by www.etfconnect.com are trading at a premium.

That’s well below the 35% to 50% historical average. Granted, right now is not the “sure-thing/things can’t get any worse” type of short-term bottom we saw when only 3% of CEFs were trading at a premium. But at 22.9%, its clear bearishness is pretty strong.

That’s why we’re starting to look for the light at the end of this short-term tunnel.

Buy Fear, Sell Confidence

Right now investors are clinging to the sidelines. Money market fund assets are at $2.8 trillion. The 10-Year U.S. Treasury Bond has become so popular it now yields a mere 2.94%.

Even private equity firms, which are notoriously aggressive with massive financial leverage (a.k.a. borrowed money) and other people’s money, are sitting on $500 billion cash according to the New York Times.

Despite all the negativity, the makings of a turnaround are forming.

Fear is high and values are getting more enticing. Meanwhile, investors are getting practically no return in safe investments.

It seems like everyone is hoping for some good news. And it probably won’t be long until we get to a point again where good news comes or, as hope grows, we reach a point where bad news “isn’t as bad as expected.”

Now is not the time to get down, it’s the time to look for the real opportunities. In the next Prosperity Dispatch we’ll look at one sector which has been absolutely decimated over the last few months while the fundamentals have only improved.

Until then, good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

Editor’s Note: Discounted CEFs are a great way to wade back into the markets with less risk and more reward than stocks. Closed end funds are offering some stellar values right now.

In our most popular premium advisory service, Andrew Mickey’s Prudent Investing, we’ve used them to maximize returns and reduce risk by buying them when the discounts to NAV are just too extreme.

There are currently two of them recommended both trading at significant discounts to NAV. One is trading for 25% less than NAV. It’s like buying stocks for 75 cents on the dollar. The other we’re up 90% on and earning effective yield of more than 15%.

The information contained on this e-mail and in other Q1 Publishing communications is intended for general information purposes only. Q1 Publishing has not taken into account the specific investment objectives of any particular investor. You should always seek the counsel of a professional financial advisor before purchasing or selling stock. Directors, employees and outside contributors to Q1 Publishing may hold substantial positions in the recommended securities and may increase or decrease such positions without notice. We believe the sources of information to be reliable but Q1 Publishing does not guarantee the accuracy or completeness of the information provided on this website or in other Q1 communications, and expressly disclaims liability for any errors or omissions that may be contained in the information.

-- Posted Friday, 2 July 2010 | Digg This Article