May 12, 2003

I had several subscribers ask me about the small daily range in the S&P 500 that I discussed on Tuesday. The question was whether this type of low volatility is common to May, or if we are seeing something unusual. To answer, I went back to 1965 and checked the 10-day average range in the S&P across all months. The averages were consistent across all twelve months, although October did show a slightly higher average range than the others, which shouldn't be a huge shock considering some of the events we've seen during that month. So, the low-volatility condition we're seeing now cannot be dismissed to some seasonal pattern.

The optimism expressed by individual investors has become quite extreme. The latest AAII survey came in with 63% bulls and only 16% bears, which comes out to a bull ratio of 80%. This is in the top 3% of readings over the past 16 years. If we look at how the S&P performed after such bullishness among this group, the results are not encouraging for those looking for higher prices:

	2 Weeks	4 Weeks	8 Weeks	12 Weeks
When AAII Bull Ratio is 80% or above...
Avg. Return	(1.0%)	(1.6%)	(4.7%)	(4.4%)
% Positive	26%	32%	21%	42%
Random...
Avg. Return	0.3%	0.6%	1.2%	1.8%
% Positive	58%	59%	62%	67%

We can see from the table that 2 months after a bull ratio reading of 80% or greater, the S&P returned an average of negative 4.7%, with only 21% (4 out of 19) instances leading to a market that was positive. It should be noted that one of these readings was (22.2%), which was recorded before the crash in 1987. I think it's safe to consider that an outlier, so without that instance, the average return becomes (3.5%) - still troublesome considering that a random 8-week return during that period was positive 1.2%. I must also note that it's difficult to come to a significant conclusion with only 19 instances to consider.

We now have three distinct groups of traders expressing what can be considered an extreme amount of bullishness - the individual investors surveyed by AAII, the newsletter writers of Investor's Intelligence and the futures traders polled by Market Vane. This covers a relatively broad cross-section of traders, so it appears as though the supposed "wall of worry" that stocks have been climbing is only about ankle-high.

While equity option traders have been trading heavily in call contracts (driving the 10-day average of the QQQ-less equity put/call ratio down to a dangerous level of 0.55), OEX option traders continue to build up put positions while neglecting calls. In fact, call open interest actually declined yesterday, which is an extremely unusual situation and hasn't happened since January. Currently, the OEX put/call open interest ratio is a very large 1.75, meaning there are 1.75 puts open for every call - this is the highest level in nearly four years. OEX traders have a decent record at calling market turns (certainly much better than equity option traders), so this data should be considered in a non-contrarian manner. Therefore, such a large amount of bearish bets being placed by a more sophisticated group of traders should be taken as a negative for the market.

The increasing bullishness shown in the surveys has contributed to the low score currently being given by the Indicator Score chart posted to the site (not yet updated with today's figures). This score is based on 24 intermediate-term sentiment indicators, and how stretched they are from their mean. A high score suggests there is excessive pessimism and higher stock prices are likely, while a low score means that optimism is rampant and it would be difficult for equities to make much more headway. As of today, the score will be below 80% for only the fifth time since May 1999. The others were January 2000, January 2002, March 2002 and November 2002. Considering that we are still not in a weekly uptrend, it cannot be considered positive that so many have embraced this rally whole-heartedly.

Not much in the market has changed, so my stance has not either. Excessive optimism in the fact of a neutral market (at best) means that the odds are titled heavily in favor of declining prices out several weeks at the very least. As of today's close, many of our shorter-term measures are beginning to also show some extreme optimism, so higher prices on almost any time frame will likely lead to better selling than buying opportunities from a risk/reward perspective.

On a side note, for those who monitor the bond market, it should be noted that the extreme pessimism in that market in early April (when bond futures were at 111) has dissipated (now that they have exploded to 118). This doesn't suggest one should sell bonds, but it does remove one leg of the stool supporting bond prices (and suppressing yields).

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.

I mentioned this weekend that our Down Pressure indicators on the S&P 500 and Nasdaq 100 would not become overbought unless we saw at least one (but probably two) more days of a rising market. What we got was good enough, as both of them have entered overbought territory as of today's close. These indicators measure the amount of selling pressure currently being seen in arguably the most important stocks in the market, based on volume patterns and the amount of actual points gained or lost. The indicators themselves are aggregations of the selling seen in each individual security. When they reach either extreme, it has been an effective notice that selling pressure has become too heavy (or too light) and whatever trend currently in place is likely to take a breather over the next 1-3 days. Since the indicator is now overbought, it suggests there has been an extreme lack of selling pressure. While that might seem bullish on the surface, when it reaches this level of extreme, it is typically unsustainable (unless we're in the immediate aftermath of an intermediate-term low). These indicators have reached this level of overbought twice in the past month (April 22nd and May 5th), both of which preceded the usual two or three days of weakness. Today's reading suggests we might reasonably expect a similar result.

Those of you who trade actively or watch the market carefully have undoubtedly noticed the lack of range in the major indices. It has gotten to the point now where the average range (high - low) in the S&P 500 cash index over the past 10 days is less than 13 points, the lowest since January 2002. This is more than just an annoyance to day-traders - it is a warning sign that a certain level of comfort has set in. When there is something of a consensus among market participants as to likely future market direction, volatility dies down since the number of variant perceptions has dwindled, and the usual push-pull between bulls and bears is largely absent. This is a relatively constant feature of popular markets, and has been especially pronounced over the past five years. The following chart demonstrates this point clearly:

The black line in the top section of the chart is the S&P 500, the blue line in the lower section is the average range of the S&P over the past 10 days, and the red vertical lines highlight those instances where the average range has dipped to a level similar to our current one. It is obvious from the chart that when there is such a lack of difference of opinion, the market has had great difficulty is sustaining its upward momentum. One notable exception is the mania in 1999, when the market continued to climb higher no matter what. I should also note that while the absolute range in the S&P is currently very troubling, when expressed as a function of price, it is not quite as extreme as it was in September 2000 and January 2002.

I've been asked to comment on the action in the Rydex Ursa fund on Friday. This fund moves inversely to the S&P 500 index, so when the S&P rises 1%, this fund should decline 1%. More than 90% of the time it sees an outflow of assets when the S&P rises on any given day. Last Friday, even though the S&P rose more than 1%, assets in the Ursa fund jumped by over $130 million - a 26% increase in its asset base. This is certainly NOT typical behavior, and I find it highly unlikely that retail traders all of a sudden decided to fade the market and invest in Ursa. More likely, it was mostly due to an institution that was using the fund to hedge or speculate that the gains in the S&P would not hold. Over the past three years, when the S&P rose on the day, the Ursa fund saw an asset increase of more than 10% only four other times (10/05/00, 03/08/01, 07/11/02 and 09/09/02). Interestingly, each instance preceded a major spike down in the S&P of anywhere from 7% to 15%+ over the next few weeks. While it's impossible to draw any conclusions based on such a minute sample, one has to wonder whether a large institution was positioning itself for a (substantial?) decline, and was using the better prices on Friday to do so. The assets held relatively steady on Monday considering the market was up again, so it does not appear as though that institution (if that is what it was) has unwound the trade.

My outlook has not changed over the past couple of days. The larger trend is still neutral or down depending on how I view it, and such grossly overbought internals along with enthusiastic sentiment presents a situation where shorts are favored over longs with a time frame out several weeks at the very least. In the short-term (under 5 days), the lack of selling pressure recently seen argues that further gains are likely to be exhausted fairly quickly, and here as well, shorts are favored.