Stuck in Neutral

I discuss the ROBO put/call ratio^TM frequently, because I think it’s an important look into the real-money activities of those we know, for a fact, are small traders. Recall that this indicator looks at the purchasing of puts in opening transactions of 10 option contracts or less compared to the purchasing of calls in opening transactions, also for 10 contracts or less. This data removes the biggest arguments against traditional put/call ratios (such as from the CBOE) in that with those ratios we don’t know the size or strategy behind the numbers. Here we know both.

The average size of the trades making up the ROBO ratio were generally between $175 and $2100 this week, so we know we’re talking about the smallest of traders here. Also, we narrow the subset down to option purchases to open only, and we know the strategy behind the trades – these traders buy calls to speculate on rising equity prices, and they purchase puts to speculate on falling prices. There are few, if any, complex option or equity replacement strategies here.

The ROBO p/c ratio for last week came in at 0.33, which is by far the lowest ratio seen at any time since December 2000. Since the week ended 10/17 through this past Friday, a time when the S&P has gained a whole 11 points (but lost a maximum of 21 points and gained a maximum of 24 points in between), these traders have purchased a total of 3.9 million calls, but bought a total of only 1.5 million puts. Again, these are opening transactions only, so it’s safe to assume that we’re talking about a great emphasis on upside speculation versus downside protection in a flat market.

I’ve said before that the selling of calls against existing stock positions is a popular strategy for these traders, as they agree to cap the potential gains on their stocks in return for a little extra cash on the side, just in case their stocks decline or hold steady. In fact, this was the predominant strategy that these guys employed throughout the bear market. For the past three years, it has been rare to see a week go buy where call buying accounted for a greater percentage of the volume than call selling. Only twice has that happened for two weeks in a row – until now. Since early October, call buying has outpaced call selling for five out of six weeks. Bullish options strategies (call buying and put selling) has outpaced bearish strategies (call selling and put buying) all six weeks, and has now reached a point where bullish strategies account for almost 60% of total volume. Once again, that is a pace unseen since the bubble days.

These traders have undergone a shift in psychology – from one of conservatism in protecting their existing stock positions, to one of outright speculation on more gains in the stock market. It is clear that the smallest of options traders, those that lore says are the most likely to lose their money, believe the bull market is back and here to stay. Scary.

Over the past few months, I’ve touched lightly on some of the extremes in the various sentiment surveys. Every one of the five that I follow is at multi-year extremes, which is not surprising to anyone. I suspect that if this bull move continues, we will see all of the surveys carve out a higher trading range such as we saw in the mid-1990’s, when “normal” readings for the surveys showed a higher level of bullishness than we’ve seen over the past couple of years. However, I still think it’s important to point out these extremes and keep them on your radar. When we see all five surveys in extreme territory, it shows us that a broad cross-section of investors – from small retail traders (AAII, lowrisk.com) to commodity futures traders (Market Vane) to newsletter writers (Investor’s Intelligence) to brokerage house analysts among others (Consensus) believe that the market is headed higher. That is a true confluence of bullish opinion.

It should be noted that the Consensus survey has now recorded more than 64% bulls for four out of the past five weeks. An eight-week moving average of this data is sitting over 61%, which is the most sustained level of high bullish readings in more than 5 years - we have to go back to the Spring of 1998 to see a higher reading in the eight-week average. Each time this average approached even 55% over the past five years, it almost invariably lead to an imminent stiff decline. However, the average approached or exceeded 70% several times over the past 15 years (1989, 1991, 1995, 1996, 1997 and 1998), mostly with little effect on the uptrend that was in place. From the type of price persistency we’ve seen with this uptrend, and the studies I’ve shown in the past that say it usually continues for quite some time, it certainly appears as though this time is different, compared with other times over the past 5 years. This means, of course, that such overbought readings could be given considerably less weight. I’m just wary of the thought that once everyone concludes that “this time is different”, like the small options traders discussed above, then that’s usually when we find out that it isn’t.

Bottom Line: A lot of money poured into stock funds last week, but the bullish implications are questionable.

I’ve talked before about fund flows, and how large one-week deposits into equity mutual funds is not necessarily a good omen for the next week, contrary to a lot of what I hear. Instead of giving you my opinion, let’s just look at the facts. The table below shows the five weeks with the largest outflows from equity mutual funds since March (using data from AMG), and the return in the S&P 500 from the day the figures were reported until one week later:

Week Ending	Flow ($)	Gain/Loss Next Week
03/12	-3.0 B	+8.7%
10/01	-2.2 B	+1.5%
06/25	-1.6 B	+1.9%
11/05	-854 M	+0.6%
04/30	-796 M	+1.4%
AVERAGE		2.8%

Week Ending	Flow ($)	Gain/Loss Next Week
04/16	+5.7 B	+4.4%
06/18	+4.3 B	-3.4%
09/03	+4.2 B	-1.5%
10/08	+3.6 B	+1.3%
08/13	+3.5 B	+1.7%
AVERAGE		0.5%

If we look at the weeks with the 10 highest inflows, the average return over the next week is still 0.5%, with 5 of the weeks ending positively, and 5 negatively. In contrast, after weeks with the highest outflows, the average return was 1.2%, with 8 of the weeks ending positively. I don’t think it’s wise to become exceedingly bullish because there was a lot of money going into stock funds last week – the history of doing so isn’t terribly inspiring.

Bottom Line: The conclusion that bonds are an ideal short is not necessarily supported by some sentiment measures.

Every once in a while, I’ll touch on other markets that have an impact on stocks. The largest of those, of course, is that of bonds, as interest rate movements at times have a profound influence on equity movements. I’ve shown several times that the solid inverse correlation between stocks and bonds broke down this Spring, and since then any consistent correlation between the two markets has been hard to find. Over the past two months, however, the inverse correlation between the two has kicked in again. Since mid-September, the correlation between 30-year Treasury Bond prices and the S&P 500 has been -0.74 (on a scale of +1 to -1). This means that when bonds rise (and by extension, yields fall), stocks have declined a majority of the time. This does NOT mean that one causes the other, but it does mean that their movements have been tight. By looking at bonds, we are assuming that the correlation we’ve seen over the past couple of months will continue, and I’m not entirely sure that’s a valid conclusion, so reader beware.

One of my favorite reflections of sentiment towards the bond market is the interaction between commercial traders and small speculators in 30-year Treasury Bond futures. Unlike in the S&P 500 contract, there is no erratic movement in an e-mini contract to distort what may be going on behind the scenes. Currently, small speculators in the Bond contract are the most net short they have been in over six years, while commercial traders have been building up a substantial net long position. The variance between the two, which is simply the commercial net position minus the small spec net position, is now close to an all-time record high, going back to the inception of the data in 1986.

The chart below shows a 12-week moving average of this variance (the blue line). When the indicator is near the upper end of its range, it shows that commercial traders are largely net long and/or small specs net short. On the other hand, when the indicator is low, it shows that commercials are net short and/or small specs are net long.

We can see that not only are bonds still in a long-term uptrend, but the commitments among the various traders are at one of the most positive points in 17 years. Obviously, this information is not fool-proof, as it reached an extreme in 1993 while bonds continued to decline.

One other telling reflection of bond sentiment is the asset allocation in the Rydex funds. If we look at how much money is in the Bond fund (which benefits when bond prices rise) compared to what is in the Juno fund (which benefits when bond prices fall), there is an overwhelming preference for the short side. It is to the point now where assets in Juno fund are 20 times what is in the Bond fund, and make up 95% of the total assets in the two funds.

Over the past three years, there has been a clear shift of assets from the Bond fund to Juno, and rallies in the bond market now barely budge the assets in either. These traders are firmly convinced that yields are headed higher.

I have been hard-pressed to find an article praising the possibilities of a rally in the bond market for months on end now. But it’s extremely easy to find one talking about how gold, the dollar, inflation, a pickup in the economy, etc. are going to wreak havoc, causing yields to shoot higher. This type of talk has certainly caused smaller traders to bet on the short side of bonds, and they are now historically so. Also, Market Vane is reporting 47% of its respondents as bullish on the bond market (as opposed to 87% near the peak), while Consensus is reporting only 26% as bullish (as opposed to 60% near the peak). I, too, am swayed by the fundamental arguments against bonds. But looking at this data makes me wonder if perhaps too many traders are taking obvious statements for granted.

I said last week that I thought any breakout to new highs would quickly fall back, and we saw that in spades on Friday. There is simply too much of a willingness to believe in the “new bull market” that higher prices are met with an instant and unrelenting demand to get long. As we’ve seen for a couple of months now, such speculative fervor has not allowed us to enjoy a meaningful advance. I’ve also been saying that even small declines get traders too anticipatory of a major change in trend, thus we turn right around and screw them too. This type of behavior has lead to a choppy market that is likely frustrating a great number of traders.

I’ve been willing to give the uptrend the benefit of the doubt on declines, meaning I don’t want to short the market when it’s already down, but I’m seeing some things now that are troubling me more than before. The activity of small options traders, discussed above, frightens me to no end, as these traders don’t exactly have a stellar track record. The fact that they’ve bought nearly three times as many calls for every put in a flat market is not comforting to me. When we add in the information from other put/call ratios, the Rydex data, the sentiment surveys, volatility measures, etc., it is abundantly clear that there is a great level of comfort among those traders who are historically terrible market timers. Whether you believe we are in a new bull market or not, this information should not make you comfortable, too.

The broader market feels very “tired” to me, and every rally to new highs is quickly met with supply. However, I still haven’t seen enough of a failure to want to be aggressive on the short side – as I’ve been saying, I want to see an inability to hold new highs (already done), an inability to rally from short-term oversold conditions (still OK here), and a break of obvious uptrend lines (still OK here, too). While I think the upside is limited, I don’t yet see an opportunity to make high-odds short sales.

This disclosure is not intended as trading advice in any form. It is meant as a note to subscribers that the author may have a position directly affected by the market outlook reflected in the commentary. Although the author takes great pains to remain objective in any commentaries, it is only fair that readers should know that the author may have taken positions in accordance with his market outlook. Positions can and do change at any time, without notice to the reader.