Aug 25, 2003

Once again today, the CBOE put/call ratio closed at a very high level. Earlier this week, I discussed the unusually high put/call ratio seen on Monday and what implications it may have on the broader market. While the headline put/call number gets all the attention, I can’t help but continue to point out the distorting effects of QQQ options. The headline put/call ratio today was 1.08, but if we back out QQQ options, then it falls down to 0.83, which is about average in terms of recent history. Over the past three days, the headline ratio has averaged 1.06, but the ratio without QQQ options is only 0.89.

Why back out QQQ options? I’ve gone over this topic many times, so suffice it to say that it is largely an institutional vehicle and I don’t believe it is representative of a contrarian indicator. I’ve shown the QQQ put/call ratio several times in the past, and it is clear that there is no pattern to it as either a contrarian or non-contrarian indicator. Sometimes high QQQ put/call ratios lead to rallies in the QQQ, sometimes they lead to declines. As I’ve said before, I find this ratio no better than random, so if we can back out this “noise” from the general put/call ratios, I think that’s valuable.

This noise is getting increasingly loud. The chart below shows QQQ put volume as a percentage of total equity put volume.

We can see from this chart that QQQ put volume now regularly exceeds 30% of total equity put volume. About one year ago, the 100-day average (the black line) stood around 10%. Now it is over 20%. Any single sector that regularly accounts for 30% or more of volume should certainly be accounted for. The chart below shows the equity put/call ratio with QQQ options subtracted out, on a 10-day moving average basis, with six-month Bollinger Bands framing it.

If we accept the above chart as being a more accurate reflection of those most often wrong on market direction (I certainly do), then the put/call ratios are far from being bullish, and are in fact only now beginning to recover from one of the most bearish (for the market) readings in its two-year history.

On Monday, I outlined the past instances of extremely high put/call ratios, and the evidence was quite bullish for the market. However, I think when QQQ options are factored in – and they MUST be – then the bullishness wears off considerably. While we could certainly see a little pop in the market after the numbers we’ve seen over the past few days, it would take many more days of the non-QQQ ratio being elevated to get me to believe that the traders most wrong on market direction are becoming too fond of put options.

Short interest on the NYSE dropped 4.2% for the month ending with trades initiated by August 12^th. This is the largest monthly drop in NYSE short interest in four years, and it is the third month in the past four that has seen short interest decline. This is quite unusual, since short interest has been in a steady uptrend for 60 years. Since 1980, 64% of the months show an increase in short interest from the month before, so to see three declines in four months is notable. On a de-trended basis (meaning the long-term secular trend in the data has been accounted for), the current short interest configuration is the lowest since December 2001. While I would not consider current NYSE short interest extremely low in an historical sense, at least compared to what was seen in 1999 and 2000, I do believe that the recent declines show a troubling trend of confidence in rising prices. This is particularly striking considering the large amount of convertible bond deals that have been brought to market in recent months, which as I’ve stated before adds demand for short shares (since hedge funds often short the stock of the issuer of the convertible bond). On the Nasdaq, short interest declined by 6% in August from the month before. This is the fourth-largest decline since 1995, beat out by a 9% drop in December 2001, an 11% drop in June 2002 and an 11% drop in May 2003.

It’s hard to read a whole lot into this week’s action with volume being so low (every day so far has been at least 20% below the yearly average), and it will be even worse on Friday before picking up again next week. Most of our short-term measures are now neutral, so I don’t see an edge for the rest of the week at this point, other than the traditional positive seasonality on Friday. Longer-term, the excessive speculation we’ve seen for months remains largely intact, and my preference continues to be on the short side unless 1015 is broken on the S&P 500.

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.

There has been a lot of commentary lately suggesting that since so many traders are taking their vacation this week, volume should be lower than normal. Historically, that does seem to be the case as the last five trading days in August have shown volume that is 4% below the average of the prior twenty-one days since 1965. Notably, only 26% of the time does the last week in August show above-average volume. The following week (the week immediately following Labor Day), volume picks up substantially, at least in relation to the prior week. It averages 102% of the monthly average, and 53% of the weeks since 1965 have been above average. For 7 out of the last 8 years, the last five trading days in August have shown below-average volume, but the following week has shown above-average volume. As far as price action goes, the last week in August has generally out-performed the week after Labor Day. Since 1965, 58% of the last weeks in August have closed positively (Friday-to-Friday close), while 47% of the weeks after Labor Day did so.

Next week will be holiday-shortened due to Labor Day on Monday. Seasonality is always a favorite curiosity of stock market investors, so I’ve been asked numerous times if Labor Day holds up to the typical pattern of strength before and weakness after. To a small degree, I would say “yes”.

The chart below shows the average return for each day surrounding Labor Day since 1950, along with how often the day closed in positive territory. We can quickly see that only two of the six days had a positive bias – the day that falls three days before the holiday and the day that immediately precedes it (per usual of the holiday pattern). The rest of the days showed a negative average return, but closed in positive territory more than negative territory by a small margin.

Also, the day immediately preceding the holiday exceeded the prior day’s high 63% of the time, with an average violation of 0.2%. It exceeded the prior day’s low only 41% of the time, and the average violation is actually a POSITIVE number. What this tells us is that when that Friday drops below Thursday’s low, it usually didn’t travel far, and the majority of the time it didn’t violate Thursday’s low at all. On the other end of the spectrum, the most negative day (two days before the holiday) exceeded the prior day’s high only 46% of the time, but the prior day’s low 54% of the time.

Overall, this is a pretty weak bias and not really anything I would base a trade on. About the only thing I would consider is to be more inclined to take long positions towards the close Thursday or during the day Friday for a day-trade, all else being equal. Although we don’t have nearly enough data points in order to validate the claim, we should also be aware that the acts of terrorism on September 11^th, 2001 may have changed the way holidays are viewed going forward. Traders may be less inclined to buy ahead of long weekends for fear of another terrible incident, particularly if the holiday carries some type of national pride or religious connotations.

The Specialist Short Ratio dropped once again during the most recent reporting period (the week ending 08/08/03). This ratio shows the percentage of total short sale activity that was done by specialists on the NYSE – the lower the number, the less shorting by specialists and the more bullish the implications, at least historically. The 52-week average of this ratio is now challenging the lowest readings in history. The only other times that come close to this low of a ratio were 1982, 1984 and 1997, all of which of course lead to significant upside.

This ratio lost a significant amount of its usual forecasting power beginning in the 1980’s, as I’ve gone over several times before. There can be no doubt that the proliferation of institutional trading has been the major factor behind this indicator’s decline, and the recent spate of convertible bond offerings adds more credence to the probability that this data is greatly compromised by the activity of hedge funds. I’ve gone over this many times, so I’m not going to belabor the point. Let me leave it at this – the impression that this data gives is that specialists have pulled back their shorting activity to an historic degree, and in the past that has been a very bullish long-term sign, but we should be aware that recent market dynamics may damper the effectiveness of this as an indicator.

For the first time in nearly three months, small speculators in the full S&P 500 futures contract reduced their net long position, and to a relatively large degree. Small specs shaved about 13,000 contracts from their net longs, which erased the past six weeks’ worth of gains. This was the largest one-week reduction in net longs for this group since mid-March. At the same time, commercial traders reduced their net short position, but only by a modest 6,600 contracts. This is a bullish change, but keep in mind that both groups remain in fairly extreme territory with their net positions – small specs are extremely bullish, and commercials are moderately bearish (in relation to recent extremes).

Today’s CBOE total put/call ratio was extremely high with a closing figure of 1.21, which is the 10^th-highest reading since 1995. If we look back at what happened in the S&P 500 each time the put/call ratio spiked above 1.20, the results are quite positive as the table below demonstrates. Twenty days later, the S&P was higher 7 out of 9 times, with an average gain of 4.2%. This is even more striking considering that every one of the occurrences happened in the past two years, except for one in 1998. Two of the readings occurred in the immediate aftermath of 9/11, and if we eliminate those readings as “outliers”, then the average return after 20 days drops down to 2.2%. Still, five of the seven remaining instances were positive.

TOP 10 CBOE PUT/CALL RATIOS 1995 – 2003
DATE	P/C RATIO	1 DAY LATER	3 DAYS LATER	5 DAYS LATER	10 DAYS LATER	20 DAYS LATER
09/18/02	1.36	-3.0%	-4.3%	-3.3%	-4.6%	0.0%
02/06/03	1.35	-1.1%	-1.2%	-2.2%	1.5%	-0.8%
03/28/03	1.31	-2.0%	2.2%	2.0%	0.7%	6.1%
06/21/02	1.27	0.7%	-1.4%	0.1%	-0.6%	-16.7%
10/08/98	1.27	2.5%	3.4%	9.0%	12.5%	17.6%
09/20/01	1.27	-1.9%	3.4%	4.2%	9.5%	10.0%
10/16/02	1.25	2.3%	4.6%	4.3%	3.8%	3.3%
09/19/02	1.23	0.2%	-2.9%	1.3%	-2.6%	5.5%
09/21/01	1.23	4.3%	5.0%	8.4%	11.7%	12.6%
08/25/03	1.21	?	?	?	?	?

AVERAGE		0.2%	1.0%	2.6%	3.5%	4.2%
% POS.		55.6%	55.6%	77.8%	66.7%	77.8%

When trying to compare these figures to those seen historically, however, we run into a big problem – put/call ratios have been trending higher for three years now. So what is extreme now is not necessarily the same as what was extreme in 1999, for instance. The chart below shows this clearly:

The bottom part of the chart shows the put/call ratio (the tan line) framed by its 252-day, 2 standard deviation Bollinger Band. The Bollinger Band is simply a 252-moving average of the put/call ratio, with upper and lower bands that frame 2 standard deviations around that moving average. At point #1, in 2000, that yearly moving average was at .52 and the upper Band was .72. At point #2, in 2003, the moving average was .81 and the upper Band was 1.13. So while a reading of .80 would have shown extreme pessimism in 2000, it would barely even be average now.

If we look again at today’s put/call ratio, except this time put in into a relative context by comparing it to its 252-day moving average, then today’s reading doesn’t even make it into the top 50 readings since 1995. Also, my preferred method of looking at the put/call ratios – the equity only ratio excluding QQQ options – barely made it to extreme territory today, with a reading of .76. It should be noted, however, that the last time we saw this high of a reading from this indicator preceded the short-term low in late June.

The excessive speculation that we saw into the middle of last week has worn off to some degree. Put options are actually getting some attention now from retail traders, and the Rydex assets flows have cooled off considerably. It would be a stretch to say we’re oversold, even mildly, but the action over the past few days has been constructive. Should it continue for a few more days, it may set up a possible short-term long-side trade into late in the week, but I don’t see much right now that would have me looking long. I continue to favor the short side for longer-term trades unless we are able to reverse Friday’s reversal session and exceed (and hold) 1015 on the S&P 500.