Hard to Short Above 1060

For the week ended this past Wednesday, the American Association of Individual Investors (AAII), in a survey compiled on their web site, showed that 69% of respondents expected the broad market to rise over the next six months, while only 14% expected it to decline. This results in a “bull ratio” of 83%, meaning that of those that expressed a definite opinion, 83% of them were bullish. This is the 12^th-highest reading in the history of the survey, covering 855 weeks going back to July 1987. In a commentary dated June 26^th, I showed how the S&P 500 performed after the 10 highest bull ratio readings in the survey’s history (I also noted that there are some major weaknesses with the methodology of this survey, so I suggest you click on the link above and check out that info).

The results showed that even during the midst of one of the strongest bull markets in history, the broader market had difficulty making significant headway after these individual investors (perhaps representative of a broader class of investors) became so lopsidedly optimistic. The average maximum gain the S&P was able to muster over the next 21 trading days was 1.4%, while the average maximum loss (drawdown, if you will) was 6.2%. Going out to 42 days, the average maximum gain was bumped up to only 1.9%, while the average maximum decline dropped to 9.2%. You will recall that we saw the 2^nd-highest bull ratio reading in history in mid-June this summer. After that instance, the market held pretty true to form, with a maximum gain (on a closing basis) of just over 1% but a maximum loss of over 3% within the next two months.

A 12-week moving average of this bull ratio is now the highest in history, narrowly beating out the two other high readings – conspicuously enough, in January and again in September 2000.

To go along with this display of confidence in U.S. equities, the Consensus survey also recorded one of its higher readings in the past 15 years. For the latest week, Consensus reported 72% bulls among its respondents, which is the highest show of optimism since April 1998 (this is not yet reflected in the chart on the site due to copyright issues). The Consensus survey, which monitors major brokerage firms and market advisors, covers a completely different segment of the investing population than AAII, so the two surveys showing such truly extreme optimism should be taken more seriously than if just one had reported skewed results. Of course, we still have Market Vane, Investors Intelligence and even lowrisk.com reporting extremely high levels of investor confidence.

The argument that I will undoubtedly receive is that optimism has been high for months now, so this week is no different. Well, yes it is. Number one, the level of confidence we’re seeing across ALL the surveys, covering a broad spectrum of traders and investors, is higher than any we’ve seen in five years this week. And number two, we’ve seen a high level of optimism (I would even consider it extreme) for five months now. If we look at a 20-week moving average of the AIM model, it is now the lowest in its 10-year history – lower even than in 1997 and 1998. Such elevated and sustained bouts of confidence do not often serve to launch explosive (and lasting) moves higher, though they frequently do lead to choppy or declining markets, whether we are in a new bull market or not.

Looking at the S&P 500 since 1950, I checked to see how December performed when the year leading up to it had been as positive as we’ve seen this year. So far this year, leading up to December, the S&P was up a little over 6% over the past two months (defined as 42 trading days), up over 9% over the past six months (126 trading days), and up over 16% over the past eleven months (231 trading days).

Generally, when the two months leading up to December have been strong, December itself tends to be mediocre. When the 42 trading days leading up to the first trading day in December have been up by 5% or more, then December has given an additional return of only 0.5% on average, with only 11 out of the 21 months being positive. If we look at the opposite end of the spectrum, however, when the two months leading up to December have been decidedly negative, then December gave an average return of a very healthy 3.9%, and every single one of the 10 occurrences were positive. This suggests that when the S&P was weak in the months leading up to the end of the year, then December performed exceptionally well; when the preceding months were very positive, though, then December performed OK at best.

If we look at the preceding six months in the same way, the results are pretty much the same, though not to the same degree. When the six months leading up to December were good, then December itself was OK, with an average return of just under 1%, and with 50% of the instances being positive. When the six months prior have a negative overall return, however, then December performed a bit better, with about the same average return, but with 60% of the months being positive.

Lastly, if we look at how the S&P performed over the preceding eleven months (January through November), then the pattern switches. Here, when the market did well on the year to date by being up more than 15%, then December showed an average return of 1.6%, with 59% of the months being positive. On the other hand, when the preceding eleven months were negative, then December lost an average of 1.2%, and 50% of the occurrences were positive.

So, basically, when the year to date was positive, then December was positive as well, on average. But, when the two months leading up to December were positive, then December was less so. How do we use that for our current situation, where both the year-to-date and the past two months have been quite positive? According to the stats above, those two facts would give somewhat conflicting ideas of what may happen this year. To take another look, I narrowed down the years to only those where the year-to-date return was 15% or better, the past six months had shown a rally of at least 9%, and the past two months added another 6% or more. This would about match what we’ve seen so far this year. Of course, when you become this specific, it narrows down the occurrences to a very small sample, and indeed in this case we come up with only 4 other years. Those four years saw December decline an average of 1.6%, with only one of the months showing a positive return (of 2%).

Much has been said that the market is not likely to decline this year because portfolio managers will be doing everything they can to protect their gains. That very well could be, but it’s all just idle speculation. If we go back and look at what has happened in the past, it should give us a better feel for what is more likely to happen, at least better than just guessing based on some anecdotal evidence. Take 1980 for example. The market had been flat to down for four years leading up to an excellent rally that year. If ever there was an incentive for managers to keep the market propped up going into the beginning of the new year, that year would have been it. Yet there was a very nasty spill in December of 1980, with the S&P down over 10% that month alone at one point (though it recovered in the last couple weeks). Yes, the markets are more dominated by professional money now than they were then, so of course things are different. But please don’t take it as gospel that the market CAN’T decline this month.

Bottom Line: The pattern continues, of jumping on new highs only to see them falter.

As the market made new highs with that nice day on December 1^st, we once again saw the symptoms that have plagued every other new high over the past few months – an overwhelming urge by wrong-way traders to buy the breakout, a strategy which just doesn’t work in the short-term. After that new high, we saw our Rydex Beta Chase Index reach one of the highest readings in its history, the Enthusiasm Index also became very high, and the percentage of assets in the money market was near its lowest point in nearly three years. All of that tells us that there was not only a willingness, but an urgent demand, to be long in a big way from retail traders. The action over the past week, however, has served to temper a bit of that madness, and in fact some of our shorter-term Rydex measures are closer to buy signals than sell signals. That is a good start, especially if the broader market is able to hold above the breakout level around the 1060ish area on the S&P 500 cash index.

Looking at another group of traders that have an excellent record of being wrong, small options traders continue to bet heavily on the long side. Our R.O.B.O. put/call ratio^TM is still hovering near bubble-market territory, which of course is not surprising, and they continue to eschew downside protection via a lack of desire to own puts. As I’ve mentioned many times, as well as looking at just the put/call ratio derived from this data, I like to look at the way these smallest of options traders (trading under 10 contracts at a time, for an average transaction between $200 and $2000) distribute their volume. By looking at what strategy these traders are employing, we can get an even better feel for their priorities. Recall that for opening transactions, since we are dealing with very small traders, we can safely assume that the following table reflects the general bias of the traders for each strategy:

STRATEGY	BIAS	% OF VOLUME THIS WEEK
Selling calls	BEARISH	32%
Buying calls	BULLISH	36%
Selling puts	BULLISH	19%
Buying puts	BEARISH	13%

We can see that for the past week, these traders distributed 55% of their volume to bullish strategies (36% for buying calls and 19% for selling puts), while 45% of the volume went to bearish strategies (32% for selling calls and 13% for buying puts).

To get a better handle on how these traders have reacted in the past, I created a very simple index based on this information. Every time call buying outpaced call selling AND put selling outpaced put buying, I gave the data a score of minus 1. This reflects a dominate willingness to bet on further upside in the market, and from a contrarian standpoint should be bearish for the market. On the other hand, for each week where call buying was less than call selling AND put selling was less than put buying, I gave the data a score of plus 1. Such a score would indicate that these traders were quite bearish, and should be bullish for the market going forward. To smooth out the flip-flopping among some weeks, I simply added up the score over the past four weeks. So, if we see a score of +4, then each of the past four weeks saw these traders employ consistently bearish strategies. Of course, a score of -4 would then reflect four straight weeks of dominant bullish strategies.

Recently, we saw a score of -4, the first such occurrence in three years. If we take a little longer view and look at the past eight weeks, then we get a score of -6, meaning that for six out of the past eight weeks, the dominant share of volume among these options traders went to bullish strategies. Of course, this is the first time since the Fall of 2000 where we got such a low score.

The most speculative of small traders believe in full that the bull market is back. While that likely gives comfort to some bulls (since a bullish mentality is needed for these guys to continue to pump money into the system), to me it is disconcerting. The effective time frame for which this data should be used is not in the short-term of the next week or two, but over the next few months. From the looks of things, these traders have been nearly hyperventilating to speculate on the long side, and in the past that type of fervor has put a cap on the upside.

In the short-term, we’re seeing a little wearing-off of the rampant optimism seen when the market broke to new highs. As I noted above, Rydex traders have been taking their licks on the bullish funds, and some of our shorter-term indicators there are almost oversold. We continue to hold that 1060ish area on the S&P that I’ve been talking about, so it’s hard to be too bearish until that level is breached and serves as something of a ceiling.

On a longer-term basis, I continue to believe the upside prospects are limited, at least until a better base if formed. As I mentioned above, a good base (meaning low risk, with high potential reward) does NOT exist when a broad cross-section of traders are almost historically bullish. But I also am not enamored with being short a market that makes new yearly highs every few weeks, so until we see a diminishing of the excessive enthusiasm that we’re seeing, or a defined downtrend, I am content to be longer-term neutral.

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.