Back to Overbought

Bottom Line: The smallest of options traders show no signs of wanting downside protection.

Each week it seems, I end up pointing out another egregious example of small options traders not fearing much of anything from this market. For the latest week, our ROBO put/call ratio^TM continued to be quite low at 0.36 as the smallest of options traders bought to open nearly three times as many calls as puts. That in itself is telling, but even more so is the distribution of the volume among the various strategies. While call selling picked up in relation to call buying, a slight sign caution (which is good from a contrarian point of view), put buying absolutely dried up. For the week ended Friday, opening put purchases as a percentage of total volume fell to an extremely low 10%. This complete lack of interest in downside protection has not been matched in nearly two years (the week ended December 28^th, 2001 showed a reading of 9%), but it was lower many times in 2000 as these traders did not believe the bull market was over. Apparently, as I’ve stated several times recently, they now believe it is back in full force.

A logical next question is “if small traders aren’t buying puts, are large traders buying them?”. Well, kind of, and certainly more than small traders. With the information we can glean from the reports that give us the ROBO put/call ratio, we can determine that larger traders, those who purchased at least 50 contracts at a time, allocated 23% of their volume to opening put purchases. Again, this compares to the 10% for trades of 10 contracts or less. I looked at other times in history where we had this wide of a spread, and the results are interesting. The chart below shows this “put spread”, which is simply the difference between large-trader opening put purchases and small-trader opening put purchases. This should give us a feel for how large traders are accumulating downside protection in comparison to small traders. The chart uses a 4-week moving average to smooth out some of the extreme weekly fluctuations in the data.

Because this is a 4-week moving average of weekly data, this cannot be used for precise market timing. Rather, it should be used to see how two different trader sets are approaching the market with real money. As we can see from the chart, generally the spread has been low near market lows (showing small traders were much more pessimistic than larger traders) while a high spread has been more consistently associated with future market weakness. Currently the 4-week average of this spread is at 11%, meaning that larger traders have been allocating an average of 11% more of their volume to put protection than small traders over the past month. This is higher than any other time over the past two years.

Bottom Line: When the current long streak of bullishness ends, it may become difficult for the market to enjoy substantial gains.

With their latest release, Chartcraft’s Investor’s Intelligence survey showed that over 58% of their respondents were outright bullish on the stock market in the near future. This marks an astounding 30^th straight week where more than 50% of the replies were bullish. I say “astounding” because this is by far the longest consecutive streak above 50% in the history of the survey (while this is technically correct, I want to note that there would have been a streak of 39 weeks in 1999 if one week hadn’t shown 49% bulls). Going back over the 34 years of history on the survey, I can count 13 other periods where we saw streaks of 10 weeks or greater of at least 50% bulls. The table below shows snapshots of where the S&P 500 was the given number of months after the streak was finally broken by the survey recording less than 50% bulls:

	1 Month Later	2 Months Later	3 Months Later	6 Months Later
After 10 or more consecutive weeks with 50%+ bulls…
AVG RET	-0.1%	-1.0%	0.3%	-0.6%
% POS	54%	46%	54%	54%
MAX	5.3%	9.6%	9.9%	10.6%
MIN	-8.7%	-21.8%	-14.3%	-15.5%
After any average week…
AVG RET	0.7%	1.4%	2.0%	4.4%
% POS	58%	60%	64%	67%

From the table above, we can see that once the streak of bullishness ends, it has often paid to become less aggressive than normal with intermediate-term investment decisions. Six months after the streaks ended, the S&P 500 was an average of 0.6% below where it was when the bulls first dipped below 50%. The market was higher a majority of the time (barely), but the maximum loss outweighed the maximum gain. If we look at any average week during the study period, the average six-month return was a healthy 4.4%, with 67% of the periods showing positive returns. This suggests that when the tide begins to turn, and investors shift their position to becoming a little more negative, it may be time to become increasingly defensive.

Each month, I’ve been showing the pattern for the upcoming month as far as seasonality goes. Now we’re entering what is historically the most positive month of the year, which you’ve no doubt heard endlessly from a multitude of sources. The chart below shows how December has averaged out over the past 50+ years. If one wanted to try to find a consistently negative time of the month, about the only thing they would come up with is from around December 8^th through the 15^th. Seven out of those eight days show a negative average return, and five of them have been negative more than positive a majority of the time.

I checked one other thing, and that was how the S&P 500 performed after beginning December with a bang, as we did today. Since 1950, there have been 7 years where the S&P jumped 1% or more on the first trading day of December. The table below shows how that index performed the given number of days later:

	3 Days Later	5 Days Later	10 Days Later	15 Days Later	20 Days Later
AVG RET	0.4%	0.5%	0.3%	1.5%	3.5%
% POS	57%	71%	43%	71%	86%
MAX	1.8%	1.8%	3.2%	6.0%	9.4%
MIN	-1.1%	-0.8%	-1.2%	-2.2%	-0.4%

We can see that the results are quite positive. 20 days later, approaching the end of the year, the S&P was higher 6 out of the 7 times, with an average gain of over 3%. The negative returns were minimal compared to the gains seen after such a positive beginning to the month. Broadening the search a little bit, when the first day of December rose by 0.5% or more, the S&P performed significantly better than when it started off with a decline of 0.5% or more. After 20 days, the S&P was higher 88% of the time when the first day was up by at least 0.5% (compared to 71% when it was down by 0.5% or more), and it showed an average return of 3.1% (compared to 1.2%).

In the last comment, I mentioned that we were finally seeing some “give-up” on the part of Rydex traders, in that they were siphoning money out of the bullish funds and putting it into the bearish ones at a pace that was greater than any similar declines since March. Not surprisingly, that came back to haunt them in spades as the S&P 500 and Nasdaq 100 have performed admirably since then. However, the Rydex traders were some of the only ones displaying the type of pessimism I prefer to see before looking too aggressively long. Options traders certainly weren’t betting heavily on the downside.

Last time, we were mildly oversold. Now, we’re mildly overbought. Pretty much the same measures that were signaling oversold conditions in the last comment are now signaling overbought (although overbought in an uptrend is not the same as oversold - it is less reliable). The broader market took its sweet time in reacting favorably to oversold conditions, and gave the impression that the type of sustainable momentum we had seen was waning. The action over the past week certainly has to give one pause in becoming too aggressively short, but I continue to see a lack of inviting indications that suggest that being aggressively long is high-odds either. I’ve been saying for many weeks now that I don’t see a low-risk, high-reward intermediate-term opportunity on either side of the coin, and that remains the case today. In the short-term, if we gap higher in the morning but give back enough to drop through the 1060ish level on the S&P 500, I think the odds are quite high that we will see further selling in the coming days.

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.