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Wednesday, May 28, 2003  7:40 PM EST

I've mentioned several times recently the reticence of the Rydex mutual fund timers to embrace this rally, and that sentiment is perhaps one reason we've gone as far as we have.  Yesterday's large, broad-based move seemed to give them a little more confidence, however, as more than $190 million flowed out of the short-side index funds and into the long-side funds.  This is the largest one-day asset flow into a bullish posture in nearly two months.  However, they are still not going in whole-hog, as less than 50% of the movement can be accounted for by the leveraged funds.  Typically, when these timers are extremely confident of direction, they will use the leveraged funds to get the most "juice" out of the move.  The fact that they are sticking with the un-leveraged funds suggests that while they may be more positive on the market than they have been in a while, they are not yet wildly optimistic.  The enthusiastic asset moves from yesterday may be considered a mild negative for the market, but I don't think it should yet be terribly worrisome.

We're also seeing some speculation take shape in the options pits.  For the last three days, the equity-only put/call ratio (excluding QQQ options) has been more than a standard deviation below its mean.  This shows quite a heavy amount of call volume in relation to puts, a sign usually seen when equity traders want to bet on further upside and get the "juice" of the leverage from a call contract, similar to the leveraged Rydex funds discussed above.  The three-day average of the equity p/c ratio is now 0.46, which is in the bottom 3% of readings over the last two years.  The S&P 500 has had difficulty making headway when we have seen such a low three-day ratio, as the table below illustrates:

We can see from the table that out of 14 instances, only once was the market higher after 5 days.  The maximum return after those 5 days was 0.6%, while the minimum was negative 4.9%.  This data suggests that a short-term splurge of call activity has had very negative connotations for the market, and lead to significantly more negative performance than random.  With only 14 occasions with which to analyze and a steady downtrend during the study period, we cannot place too much weight on these results, but they do certainly add a note of caution for the short-term.

At the same time equity option traders have been snapping up call contracts, their more sophisticated OEX-trading cousins are busy betting on the downside.  The longer-term moving averages of the OEX put/call ratio are challenging or exceeding any reading seen over the past year.  This suggests that these traders have been accumulating put positions relatively heavily, which is verified by the open interest ratio.  From the record of these traders, particularly over the past 10 years, I would prefer to not bet against them.

The buying pressure seen in the components of the S&P 500 over the past few days appears to be exhaustive in the short-term.  Our Down Pressure indicator on the S&P reached an extremely low level of 20% yesterday.  As is explained on the site, this indicator is calculated by computing the amount of points each of the components in the index gained or lost, as well as the amount of volume that flowed into those negative or positive issues.  The higher the reading, the more pressure there is on the downside; the lower the reading, the more upside pressure there is.  It would seem logical that a very low reading would be bullish, since it shows there is heavy buying pressure (or at least a lack of selling).  This may be the case near a major low, but when the index has risen nearly 12% in only a month and a half with nary a correction, it does not appear to be sustainable.  The indicator has approached this 20% level four times since July of last year.  Three of them were in the aftermath of the major lows (July and October of last year, and March of this year).  The only other extremely low reading was 21% on January 6th of this year, which of course was a signal that the buying had reached an unsustainable pace so long after an intermediate-term low.

The S&P 500 briefly took out the 955 level I had been using as a test of the 2nd "step" to verify a new bull market, however it was not able to hold it so it does not count.  Until that level is taken out - and held - we are still in a longer-term down market (or neutral at best).  As you probably know by know, my feeling is that when we see overbought market conditions, accompanied by excessive optimism and speculation like we are seeing now, the odds favor short positions over long.  Only when we have completed the four steps to a new bull market (outlined in the April 29th daily commentary, which is available in the archives), will I give less emphasis to overbought market conditions.

P.S.  For those of you wondering what happened with the short position in our intermediate portfolio, I had severe technical difficulties this morning.  I did not have access to any type of quote system or email.  The stop loss order that was set was indeed triggered, but by the time I regained my systems late in the afternoon, the market had already traded back through it.  I am going to hold the position for now, with the same stop level, and if the market trades back up through that price, I will stop the portfolio out.

- Jason Goepfert

Disclosure:  long OEX puts

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.

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