Jan 20, 2003

In the portfolio update this morning, where we took a long position, I outlined several reasons why a long trade made sense after the gap up open got filled. Although many of those catalysts have now dissipated, it looks like there may be a bit more room to rally.

In options land, there appears to be some institutional interest on the long side. Our S&P 500 put/call bid/ask bias ratio reached a high level of 8.30 today, which is the highest since 12/26 & 12/27. Here's the breakdown:

We can clearly see from the table above that there was a bias towards selling puts (surmised by a large number of trades going off at or below bid) and buying calls. This was most pronounced in the front month (February expiration) while the back month didn't show anything significant. This suggests that the traders likely expect a rally to happen fairly quickly. As always, there is no way to know from this data if the trades were simply a part of a larger strategy, which is extremely likely, and what that strategy is - even if its a bullish or bearish one. However, in the past when we have seen such a lopsided bias in these options, it has typically lead to a notable rally within a few days.

Lending some credence to this is the action in the OEX options. I view OEX option trades in a non-contrarian way, so the fact that the OEX put/call ratio has been so low (heavy call volume compared to puts) the past two days is bullish to me. In fact, today the ratio was so low that it violated its lower trading band for the first time since late July. These traders have a pretty good record at calling short-term moves, as the 3-day return in the OEX after such low ratios is .5%, with a 71% probability of the market being higher. After 5 days, the average return climbs only a little to .7%, but with a 79% probability of a higher market. The reason for the relatively small return after 5 days was one instance of a -10% return in April 2000. Without that outlier, the average return would have been 1.5%. The one caveat to reading too much into the past two days' readings is that OEX volume has been extraordinarily low this week, averaging less than 60% of its three-month average all week.

As I mentioned in the portfolio and intraday updates, our shortest-term Rydex indicator hit a new low yesterday. The RSI spread reached its minimum value of -100 for the first time in its history (approximately two years). This shows that there has been a tremendous shift in assets from the bullish funds to the bearish. The shift is particularly noticeable in the leveraged funds. Such a large and sudden change in sentiment is almost never rewarded, so today's upside is not at all surprising. These late-coming traders very rarely are rewarded when they jump on a trend with such force. I suspect today's rise will cause many of them to take their loss and reverse their position, so we should see quite a change in asset levels when the figures are released later this evening.

Short-term, we became quite oversold while approaching important support levels, so today's bounce was to be expected. The short-term condition has cycled back to neutral, but there is some evidence that the rally should continue for a bit. I mentioned earlier today that I expect the bounce to last a few percentage points, but not much further. I don't think it's likely that we turn back down immediately and make new lows, so I feel somewhat comfortable holding the short-term long position at the moment. However, I continue to believe that this rally will be sold heavily if it goes much further, so I will be keeping a tight leash on any longs.

For those of you who are looking for additional intraday commentary with a contrarian bent, I suggest you check out www.minyanville.com. The founder is Todd Harrison, a great trader and good man, and I think you will find the content interesting and useful. He's giving everyone free access to the site through January, so check it out.

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.

Administrative note: I have now added a search engine feature to the site. You will find it in the left margin of most pages, and it works like any other search engine (e.g. Yahoo! or Google), but only searches sentimenTrader.com. This allows you to search all archived articles for references to any topic in which you have an interest. For example, if you want to find information on filling gaps, you could type in "fill gap" and it will pull up the associated articles. It should prove useful, especially as additional commentaries are posted.

Today's CBOE put/call ratios were unusually low. In fact, the total put/call ratio even broke underneath its lower trading band. The reason for the low ratio was a 40% increase in equity call volume over its 3-month average, while put volume came in below its average. These violations of the lower band are rare - rarer still when the market is down on the day. Over the past 7 years, approximately 4% of days have shown a total put/call reading under its lower trading band. Of those days, 82% occurred when the market closed higher than the day before, so obviously it's relatively unusual to see such a low put/call reading on a day when the market declined. Even more unusual is the fact that the S&P dropped over 1.5% today - in the prior seven years, the previous largest market drop with such a low put/call reading was -0.6%. I checked to see how many of these low put/call days occurred within one day on either side of an expiration, and it was 30%. This is about double what one should expect if expiration was not an influence, so I think it's safe to say that these extreme readings do occur around expiration more than they "should'. However, regardless of whether these days occurred around an expiration or not, it still seemed to have a negative impact on trading going forward. Since 1995, the average 1, 3, 5 and 10 day returns following such occurrences were around 0.7% less than a random return, with the probability of the market being higher around 8% less than random on average. Since 2000, the average returns were still around 0.7% less than random, but the probability of an up market dropped from around 47% to approximately 33% (since 2000, there have only been two other instances of the put/call ratio violating its lower trading band on a day the market closed in the red - 8/16/02 and 12/24/02). Although I believe expiration had an undue influence on today's extremely low put/call figure, past instances indicate that such high call volume in relation to puts is a negative development over the short-term.

Conflicting with these put/call readings are most of our other short-term measures. In the January 5th weekly commentary, I showed a one-year chart of the top 2% of readings in the STEM.MR model. We have another instance of that tonight, as the model closed above its upper trading band with a reading of 56%. The last occurrence was December 27th and October 10th prior to that, so the past couple of signals have been quite effective at signaling an imminent upside reversal. Supporting that oversold reading are the NYSE intraday cumulative TICK (with a closing reading of -845) and the S&P price oscillator (with an extremely oversold reading of 31%). I don't want to get too far ahead of myself, but I'm fairly certain our Rydex RSI spread will also reach an extremely oversold reading when today's figures are released later tonight. However, I want to once again stress that these oversold signals in the context of a defined downtrend are not as consistently effective as overbought signals in a downtrend, so that should be taken into consideration.

The S&P has now closed in negative territory four days in a row. During the bear market, the S&P has been down four days in a row 40 times. 17 of those times went on to become five days in a row, which means that there was a 58% probability of the next day being up (thus breaking the streak). Such a persistent downtrend has actually lead to market out-performance over the ensuing few days, as the table below shows:

	1 DAY	3 DAYS	5 DAYS	10 DAYS
If the S&P is down FOUR days in a row...
Avg Return	0.4%	0.5%	0.9%	0.3%
% Positive	58%	65%	48%	45%
If the S&P is down FIVE days in a row...
Avg Return	1.2%	1.0%	1.5%	0.7%
% Positive	71%	71%	47%	41%

We can see here that after a four-day down streak, the S&P was up 65% of the time after 3 days, although the average return was only 0.5%. However, if we get one more down day and extend the streak to five days, then the edge becomes quite a bit better, as the next day was up over 70% of the time, and the average return improved considerably. After 5 and 10 days, the market didn't appear to perform significantly better or worse than random, suggesting that most of the two-three day rallies quickly fizzled out.

With the combination of four down days and extremely oversold short-term sentiment, I will be looking to go long in the short-term model portfolio should we have a gap down tomorrow (preferably a large gap down). If we open flat or gap up, I plan on holding back a bit to see what develops. I would prefer another large down day before becoming too aggressively long, but I think that's less likely than a rally from close to these levels. This would be with the understanding that we are still short in the intermediate-term portfolio with some room before we would be stopped out. In considering the commitments of traders information this week and the fact that our breadth measurements have made a large swing back to the lower end of neutral over the past four days, I am less inclined to aggressively short the market here. If (when) we have some upside relief, I will re-evaluate then to see how it is being received. Again, if any paying subscribers (or special guests) wish to receive the portfolio updates via email, please either respond to this email or fill out the short form on the Daily Overview page of the site. These real-time updates are not available to those currently on a free trial.

	BULLISH	BEARISH	BEARISH	BULLISH
	PUTS at BID	PUTS at ASK	CALLS at BID	CALLS at ASK
Front Month	51%	13%	10%	38%
Back Months	30%	23%	21%	23%