Sep 22, 2003

We are now solidly oversold on a short-term basis, at least according to our Down Pressure indicators. These indicators (which are posted to the site each day) compute the number of points gained or lost for each component of the S&P 500 and Nasdaq 100, as well as the volume flowing into those issues. As an example, for today I show that all of the components of the S&P 500 that closed down on the day lost a total of 319 points. Those that closed positively gained a total of 21 points. So the number of points lost as a percentage of the total number of points gained or lost was 94% (i.e. 319 / (21 + 319)). I then do the same thing for volume and average the readings for points and volume to come up with the Down Pressure reading for that day. I do the same calculation for the components of the Nasdaq 100. I then take a three-day moving average of those daily readings, and that is the Down Pressure indicator as posted to the site.

These three-day averages now amount to 69% for the S&P 500 and 68% for the Nasdaq 100. Both readings are just a tad below what I would consider extremely oversold, but they’re close enough to warrant a look back to see how those indexes performed after prior readings as oversold as we’re seeing now.

Let’s first look at the S&P 500, and prior three-day Down Pressure readings of 69% or above. Over the prior year, there have been 21 such days. The following table shows the average percentage return the S&P 500 displayed 1, 3, 5 and 10 days after the reading. It also shows the percentage of time the S&P was higher than the day of the high Down Pressure reading, and the most positive and most negative returns the given number of days later (close to close).

S&P 500 Down Pressure 69% or Above Past Year, 21 Instances
	1 DAY LATER	3 DAYS LATER	5 DAYS LATER	10 DAYS LATER
AVG RET	0.5	1.1	2.3	3.4
% POS	76	62	62	76
MAX	3.5	7.3	10.4	14.6
MIN	-2.7	-3.5	-6.0	-4.6

We can see that over the past year, such oversold readings lead to a bounce in the S&P the next day 76% of the time, with an average gain of 0.5%. However, we also saw a decline of 2.7% the day after such a reading, so it’s not like there’s no risk there. Overall, the results are certainly positive, as the S&P exhibited a positive average return across all time frames, it was higher a majority of the time, and the maximum return outweighed the minimum return.

Now let’s just look at readings since March of this year. So far, there have been 7 days that reached such an oversold status.

S&P 500 Down Pressure 69% or Above Since March 2003, 7 Instances
	1 DAY LATER	3 DAYS LATER	5 DAYS LATER	10 DAYS LATER
AVG RET	1.1	2.4	3.5	4.4
% POS	100	86	71	100
MAX	3.5	7.3	8.7	9.2
MIN	0.2	-0.1	-0.7	0.9

The results here were incredibly positive. The day after such a reading, the market was higher all 7 times, with an average gain of 1.1%. 10 days later, it was also higher every time, with an average gain of 4.4%, a maximum gain of 9.2%, and a minimum gain of nearly 1.0%.

Now let’s turn to the Nasdaq 100 and look at three-day Down Pressure readings of 68% or higher. The following table gives the results for the past year:

Nasdaq 100 Down Pressure 68% or Above Past Year, 31 Instances
	1 DAY LATER	3 DAYS LATER	5 DAYS LATER	10 DAYS LATER
AVG RET	0.7	1.8	3.1	6.2
% POS	58	74	71	77
MAX	4.5	9.8	17.1	21.6
MIN	-1.8	-5.1	-5.1	-5.2

Similar to the S&P table above, overall the NDX showed very positive performance after becoming so oversold.

Not surprisingly, if we look at what has happened since March, it becomes even more positive:

Nasdaq 100 Down Pressure 68% or Above Since March 2003, 14 Instances
	1 DAY LATER	3 DAYS LATER	5 DAYS LATER	10 DAYS LATER
AVG RET	0.6	1.9	3.4	6.7
% POS	71	93	93	100
MAX	4.0	7.5	12.9	11.2
MIN	-1.2	-1.8	-0.2	1.7

To go along with a short-term oversold market, we’re also finally getting some signs of a little fear for the first time in a month, according to the put/call ratios. As I’ve discussed many times, my preferred measure is the CBOE equity-only put/call ratio with QQQ options removed, which has been quite a good guide. Today’s reading closed at 0.70, which is one of the higher readings seen over the past six months. In contrast to the extremely low ratios we were seeing last week, today’s reading is the highest since August 22^nd/25^th. As we saw with the Down Pressure readings above, since the rally began in March, such high put/call ratios have preceded a very positive market environment.

CBOE Equity P/C (no QQQ) at 0.70 or Above Since March 2003, 15 Instances
	1 DAY LATER	3 DAYS LATER	5 DAYS LATER	10 DAYS LATER
AVG RET	0.3	1.1	1.7	3.3
% POS	67	80	87	93
MAX	1.9	3.7	4.2	6.7
MIN	-1.5	-2.9	-2.4	-0.3

The now-oversold nature of many of our shorter-term indicators has pushed our short-term indicator “score” to a preliminary reading of 59%. When the Rydex numbers come out later this evening, I think it will push that even higher. We have seen such a high short-term score only three other times since the rally began – March 10^th/11^th, July 17^th and August 5^th. Obviously, the March readings began the rally so we know how positive that was. The August 5^th reading kicked off the latest leg going into September. The July 17^th reading didn’t have much of an impact, though it did precede a choppy to higher market over the following week before the decline into early August. However, we saw a string of high short-term score readings in the January/February decline that didn’t lead to anything more than a rally of a day or two. This is where determining the overall trend is so important, and gets to the crux of using sentiment effectively. Oversold readings in a downtrending market are not nearly as effective (or long lasting) as those in an uptrend.

In the short-term (under 1 week), as I outlined above, we are facing one of the best *possible* buying opportunities since this rally kicked off in March. Obviously, that statement is predicated upon the uptrend still being intact, which is the $64,000 question. I’ve been saying that I would give the uptrend the benefit of the doubt unless we began to fail, and I gave three points I was looking at to determine a failure. As I said on Monday, we already got the first failure (not being able to keep above a prior high). As of today, we can add the second failure (a break of a simple trendline from the August 6^th low). The last, and perhaps most important, test for failure is how the market reacts off of short-term oversold readings. We were slightly oversold by the close on Monday, and the market was able to stage something of a rally from that, which is positive. Now we’re faced with one of the more crucial tests in many months. If we can’t rally more than a day from the readings we’re seeing now, then I think the chances are extremely high that we’re in for a longer-term decline and I would shift my focus to using rallies as shorting opportunities.

“For short-term traders, it may be interesting to look to go long for a day-trade if we break the 962 area on the S&P 500 (especially on a gap down), then trade back above it. Whether the bigger trend is changing or not, we’re currently seeing some pretty extreme short-term pessimism here, and if we break a prior low (962 from July 1^st) then reverse back above it, often there will be enough follow-through for a decent day-trade to the long side as shorts cover into the mini-panic and short-term traders seize on a common (and obvious) technical reversal. If that happens and then we fall back to exceed the day’s low, I would not continue to hold a long position.”

Obviously, I won’t be using the same levels, but if we trade below 1007 or so (preferably on a gap down opening) and then trade back above it, I would look to go long for a daytrade at least. I would keep an initial stop loss order below the intraday low in case the reversal didn’t pan out.

Longer-term, I am going to wait to see how the market reacts off these oversold conditions. As I said above, if we can’t rally soon, then that will be the third failure I was looking for, and I would then shift to viewing rallies as shorting opportunities.

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.

This week’s R.O.B.O. put/call ratio^TM came in at 0.52, a slight increase from last week’s extremely low 0.44. However, these smallest of options traders paid 24% more for their call options than they were willing to put up for their put protection, an increase of 5% from last week. The four-week average of this “demand premium” for calls is currently standing at 23%. This is in contrast to -26% in February (i.e. the demand premium for calls was 26% less than for puts, a sign of fear among these traders). It was -29% in October 2002, and -28% in July 2002. We have to go back to September and November 2000 to see as high a 4-week average demand premium for calls as we’re seeing now.

The Specialist Short Ratio for the most recent reporting period (the week ending 09/05/03) remained steady at 35%, meaning that specialists on the NYSE accounted for 35% of all short activity for that week. Historically, this continues to be extremely low, and is one of the rare sentiment indicators that suggests that the public is still too pessimistic about the market, as they continue to short it heavily. This data includes all public short activity, such as hedge funds and other supposedly sophisticated investors. Undoubtedly, it has been impacted by the large amount of convertible bond issuance this year, as I’ve discussed several times. A typical strategy for hedge funds is what is called convertible arbitrage, where the fund buys the convertible bonds, then sells short the underlying common stock. The more convertible bonds that are issued, the more common stock these funds must sell short in order to complete the other side of their trade. I don’t think we can underestimate the impact that this activity has on short-selling statistics.

In any event, when we look at this data on a de-trended basis (meaning the long-term secular trends in the ratio are eliminated), the extremes we’ve seen are beginning to wear off. The chart below is the de-trended Specialist Short Ratio as is posted to the site each week.

We can see that currently, the de-trended ratio (the blue line in the chart above) is approaching the upper end of its trading range. This tells us that in relation to recent history, the most recent specialist shorting activity is more than most that we’ve seen. It is now on a par with what was seen in December 2001 and November 2002, both of which marked limited upside thereafter. It is significantly higher than what was seen in February and July of this year, which signaled more upside ahead in the market. However, we’re quite a bit below the true extremes seen over the past five years of a de-trended ratio of 1.10 or higher. It would take a traditional Specialist Short Ratio of approximately 45% to get the de-trended ratio that high at this point, which is a huge jump from where it is now, and something we haven’t seen since March 2002.

The major sentiment surveys continue to get more and more extreme. The AIM model, which is a combination of the four major surveys, is now at the lowest level in over five years. The Market Vane, Investor’s Intelligence and Consensus surveys are now all above their 2^nd standard deviation band, and the four-week moving average of AAII is close. While this is not a huge change from what we’ve seen since June, it must continue to be on the front burners. This is displaying a tremendous amount of confidence among a wide swatch of investors, and if the market begins to turn it suggests there is a significant amount of supply which could hit the market in a very short period of time.

I’ve been asked about the CBOE’s new VIX calculation several times recently. It is supposed to take affect today, so you may see some of the data on the site changing afterwards. I’m not going to go over the theoreticals of it, but the new calculation is certainly more “pure” than the old one, and the changes were overdue. However, for all intents and purposes, there is no practical difference between the two. Since 1990, the closes of the old VIX and the new VIX have a correlation of 0.98, which is an almost perfect relationship, and means the two are essentially interchangeable. Below is some further information on the two, taking reconstructed data from January 1^st, 1990 through September 18^th, 2003:

	OLD VIX	NEW VIX
Mean	21.3	20.3
Standard Deviation	7.4	6.5
Maximum	50.5	45.8
Minimum	9.0	9.3

We can see that the new VIX has a lower mean, standard deviation and maximum value than the old VIX. This tells us that the new VIX has demonstrated lower overall volatility than the old VIX, and for the most part has a lower general trading range. For example, if we consider a two-standard deviation move to be significant, then on the upside that would equate to 33.3 on the new VIX (20.3 + 6.5 + 6.5) but 36.1 with the old VIX (21.3 + 7.4 +7.4). Only rarely have the two indicators deviated even slightly, so at the moment I don’t think this change should cause undue concern. However, when the CBOE rolls out futures and options on this new VIX “security”, then that bears closer scrutiny. At that point, we may have artificial pressures on the index that we didn’t have before, and it may be wiser to just continue using the old VIX (new ticker symbol: VXO).

It was quadruple expiration last Friday, which means that equity and index options, index futures and stock futures all had their September contracts expire. This was undoubtedly a large reason for the tremendous change we saw in the S&P 500 futures contracts in the latest Commitments of Traders report, released this afternoon for the week ending last Tuesday. While the contracts themselves didn’t expire until Friday, the combination of the looming expiration, and option expiration as well, had a large impact. I’ve shown several times before how the week of and the week before expiration account for most of the largest changes in S&P 500 futures positioning.

In any event, for the latest week, large commercial traders in the full S&P 500 contract became less net short to the tune of just over 41,000 contracts (by adding nearly 50,000 long contracts to only 9,000 short contracts), while small speculators reduced their net long position by nearly 29,000 contracts (by adding 26,000 short contracts and reducing longs by 3,000 contracts). Both moves are large historically. We can see a similar remarkable swing in e-mini positions, as commercials became shorter by 83,000 contracts while small specs became longer by 121,000 contracts.

Note that these changes were not due to the contracts themselves expiring, as was the case in June. In fact, there was in INCREASE in total positions this week – this tends to be a recurring phenomenon, as there is a surge in positions the week before expiration, then a drop off as the contracts expire, but not to this degree. In a cursory review of this data since its inception in 1986, I can find only one other instance where we saw such a large change (as a percent of total positions) during the week before expiration – March 2003. At that time, there was an eerily similar change the week before expiration, as commercials added 42,000 long positions to only 4,600 short positions. That kicked off another four weeks of commercials adding to their net long positions as the market rallied.

I’m not sure how much weight to give these readings. On the surface, it is certainly better news than we’ve seen in some time from this data. But with September being a “major” expiration and quarter-end, there are numerous games being played in the futures markets (even more than usual). So, at this point, I’m not going to read much of anything into the numbers, and will prefer to wait until the affects of expiration are over to see what trend develops in the data. If commercials continue to add to their longs (and small specs to their shorts) as we saw in the Spring, then it would be another indication that this rally may have more steam.

As I said last week, post-expiration tends to have a negative bias. However, at least recently, once you get the first day out of the way (i.e. today), things get quite a bit better. Out of the 6 expirations we’ve had since the March low, if you had bought the S&P 500 cash index at the close the day after expiration, you would have shown an average profit of 0.8% by the next day’s close, and you would have had 5 winners out of those 6 occurrences (the one loser was a loss of 0.1%). Three days later, you would have still been profitable 5 out of the 6 times. Your average gain would have been only 0.7%, but once again the largest loss (close-to-close only) would have been a meager 0.1%. After 10 days, not surprisingly, you would have been profitable every time, with an average gain of 2.5%. The largest gain was 5.2% and the smallest was 0.5%. Please note that this DOES NOT hold up over longer time periods, but it has been the pattern recently.

Last week, I outlined several things that I was looking for to determine if this rally was failing. They were reversals at a prior high (especially if we gapped up in the morning then reversed), a break of a simple trendline from the August 6^th low, and the inability of the broader market to rally off short-term oversold readings. I would say that we got the first sign today, as we broke and then fell back below the early September highs. Now we’re faced with the last two tests at the same time – we’re mildly oversold in the short-term, and we’re resting right on the trendline from August 6^th. If we continue to decline over the next couple of days without much of a bounce, then that will increase my confidence considerably in looking at further bounces as possible low-risk shorting opportunities. However, unless or until we get those last two failures, I’m going to continue to assume that the higher-odds bets rest with looking for long opportunities off of solid short-term oversold readings.