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  A Little More Progress

July 13, 2009

 

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This is an abbreviated sample of a comment posted for subscribers

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Since mid-to-late April, it's been difficult to find much among our indicators and studies that was bullish for the market, and that turned especially so in early June.

 

The correction since then has helped, and we're starting to see a trickle of compelling extremes the other way.  We touched on one last week regarding the exceptionally low number of 52-week lows on the NYSE.  A couple more popped up on Friday.

 

One of the measures that has held up fairly well is a kind of breadth measurement of traders in the Rydex family of mutual funds.  This indicator tracks how many of the sector funds that Rydex offers have assets greater than the average over the past 50 days.

 

When we see too many funds with higher-than-average assets, it has been a good tip-off that traders are feeling comfortable holding equities, and as a result we very often see stocks decline instead; when traders pull out of the sector funds, and instead head to the money market fund (or pull their money from Rydex entirely), then stocks often bottom soon afterward.

 

We're close to the latter point now.

 

 

During a bear market, overbought signals work better than oversold ones, and this one is no different.  Several of the "buy" signals were premature by several days or weeks, and the one in the fall of 2008 was simply a miserable failure.

 

Also, the oversold level of 20% is a minimum - we usually see it continue lower to 10% or so before a decent bottom or tradable rally forms.  So we're still early in the oversold process here, but it's definitely something to keep an eye on in the coming days if stocks continue to slide and Rydex traders pull more money out of the sector funds.

 

Another measure that triggered an extreme last week is one that's a bit more difficult to get a handle on.  This is a weekly tabulation of how much volume large traders concentrated on buying call options.  These traders buy 50 or more contracts at a time, and it usually works in a contrary manner - the more calls they buy, the worse the market does going forward, and vice versa.

 

 

We track similar data for the smallest of options traders, and I'm comfortable with the idea that they are purely a contrary indicator.  To be considerably less tactful, at the extremes the smallest options traders are truly dumb money.

 

But the largest of options traders should be smart money, right?  If they have all that money, then they should be better traders - or at least that's the theory.  The options data we track doesn't prove that out, but there could be an alternate explanation that holds more water than it would for small options traders.

 

If these large guys and gals are pulling back on call options (supposedly a sign of pessimism), then it may not be that they're not pessimistic after all - they could simply be buying stock instead, and have less use for call options as a stock replacement (a popular strategy among hedge funds to reduce risk).  So in reality they are quite bullish when we see instances like the current one with low call buying volume, which would fit with the idea that indeed they tend to be smart money.

 

Whatever the underlying explanation, historically the market tends to rebound following periods when large trader call buying is low, like it is now.  I would be more confident in a looming rally if the percentage dipped to 22% or so like it did near prior lows, and also if we had more supporting data from the small-trader R.O.B.O. Put/Call Ratio, which we don't have right now.  So I would consider this one to be only kinda-sorta on the bullish side of the ledger.

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