Sunday, June 8, 2003
When a reversal may not be a reversal
Did the market suffer a key reversal day on Friday? Maybe not. I looked at all instances in the past 40 years where the S&P 500 met the following conditions:
The results suggest that these types of days did not necessarily lead to further weakness in any period from 1 to 20 days forward. In fact, overall, they lead to a bit more POSITIVE action in the S&P than a random period. The only unusual weakness I found was that the high of the “reversal” day was exceeded in the next 5 trading days about 56% of the time. This compares to a random day of 80%. So while it did not necessarily lead to further market weakness, it also didn’t lead to an immediate rebound in a large number of cases. Some other factoids:
Granted, I left a few things out of this study, such as where the market opened (always a tricky variable because of how cash indexes like the S&P 500 are opened), and how extended sentiment was at the time. If we include too many variables, then the sample size gets so small as to render the results statistically meaningless.
While these statistics are interesting, and potentially useful, they are NOT meant as the basis for some type of trading system. The odds of future market performance are taken in a vacuum and do not consider other, perhaps more important variables.
So what can we take from this? I think the most important factor is that if the market reverses course immediately (again), and we begin to head higher (again) early next week, then there is a very good chance Friday’s reversal will not prove to be all that important. Follow-through, it seems, is everything.
Don’t Fear the 13th
I had a subscriber ask if Friday the 13th (which will occur this Friday) is always a down day for the markets. The answer is…nope. In fact, the 13th is no more or no less to be feared than any other Friday, or any other day at all. Out of 89 Friday the 13th’s since 1950, 51 of them have closed positively on the day, with an average return of 0.1%. The largest gain was 3.3% and the largest loss was 6.1% (in 1989). Six out of the last ten occurrences have been positive. I don’t see anything else particularly special about the coming week’s seasonality either.
The Smart Money…
When we interpret a sentiment measure, one of the first things we need to do is determine if the group of traders we are observing is “smart money” or “dumb money”. Those two terms have become common language for those who usually get market direction correct (smart money) and those who are usually wrong (dumb money) when the market reaches one extreme or the other. With many of our indicators, we cannot separate out who is buying and who is selling, what their positions are, or what their general market outlook may be. But with some, we can do that very thing, and it often provides a useful guide to what the market may hold in store. When we look at the indicators that show us what the (usually) smart money is doing, it appears as though they are still not betting heavily against this rally.
In the S&P 500 futures pits (full contract), commercial traders are not necessarily scurrying to get long in here, but they have been reducing short positions, even while the market rises. Over the past three weeks, their long positions have held steady while short positions have dropped by around 6,000 contracts. That’s not a large amount, but considering the fact that the S&P rose over 5% during that time, it is quite unusual. As I’ve been saying for two months now, the activity here is unusual in an historic sense, and I don’t think that should be ignored.
I must also mention the activity in the e-mini contract. During the latest reporting period, ending this past Tuesday, commercials are holding an all-time high in short positions, at over 512,000 contracts. However, they also added quite a few longs, so their net position is not near the record set about a month ago. When I first began mentioning the e-mini contract due to the increasing position size, my initial thought was that the full contract should be considered in the intermediate-term while the e-mini may be more effective in the short-term. That worked for a short while, but overall it’s been useless. Since the positions in the e-mini have grown exponentially over the past year, I believe it is a factor that didn’t really exist before as far as analysis of the full contract goes, but since it is likely that different commercials trade the e-mini than trade the full contract, I’m still unsure as to how it should most usefully be interpreted. In the interim, I am not reading a whole lot into the large commercial short position in the e-mini until its track record as a potential forecasting tool becomes better known.
To show just how fast the e-mini has grown, the chart below shows the total number of long and short positions held by commercials and small specs in both the full contract and the e-mini.
We can see that in the past two years, positions in the e-mini (red line) have gone parabolic, while full contract positions (green line) have grown only modestly. The actual dollar value of the full contract is five times that of the e-mini, so just looking at the number of positions instead of the value is a bit misleading, but I simply wanted to show the relative growth of the two contracts. The spikes in the data are due to contract expirations.
One other smart money indicator we can monitor is specialist short activity on the NYSE. Over the past three months, while the S&P rose more than 12% (as of two weeks ago, Friday to Friday closes only), the Specialist Short Ratio only rose from 32% to 34%, with a high of 38% and low of 29% during that time. Overall, this continues to be unusual activity, as normally we would see specialist shorting pick up as the market rallied. I’ve presented the case a couple of times over the past few weeks why this may, in fact, be an important signal that “this time is different”, and we may be in the nascent stages of a new bull or expanded trading-range market.
Throwing a bit of water on the argument that the smart money is not betting against this rally is the action in OEX options. As of Friday, the OEX put/call open interest ratio made a new bear-market high of 1.87, the highest ratio seen since mid-December 1999. Not surprisingly, the regular (volume) OEX put/call ratios are also approaching three-year highs. These traders have a better-than-decent track record at calling market extremes, so the fact they have been betting against this rally at a pace as great (or greater) as any rally in four years should raise a note of caution.
The Dumb Money…
We looked at what the smart money is doing in the paragraphs above, so how about the other side?
In the S&P 500 futures, small speculators are also going against their historical norms by not buying into this rally with gusto. Since April 1st, while the S&P has rallied 13%, small specs have actually decreased their net long position by about 14,000 contracts. As a contrasting example, when the S&P rallied 14% from October to November 2002, small specs increased their net long position by 23,500 contracts. That fits with the usual pattern – as the market rallies, commercial traders sell into it while small specs buy more. That pattern began to break down in March of this year, when both sets of traders were doing the opposite of what they usually do. That was a strong signal (which I pretty much ignored, to our detriment) that this rally was different from those recently past.
In the e-mini contract, the opposite has happened, as small specs have once again set a new all-time record net long position, at over 412,000 contracts. Like I said with the commercials above, it’s hard to read too much into this because of the short history and lack of timing accuracy, but it should at least be noted.
I mentioned the fact that specialists on the NYSE are not shorting this rally heavily, as they had done with previous rallies. However, the public is not shorting particularly aggressively, either. Public shorting on the NYSE as a percent of the total went from an extremely high 55% in March to a year-low 45% in early May. Since then, it’s gone up just a bit (to 48%), but compared to its range over the past couple of years, it’s still relatively low. This tells us that while specialists haven’t been aggressive sellers, neither has the public in general. Historically, public shorting remains high (as I outlined the past few weeks), but is somewhat low compared to recent readings. While I wouldn’t yet consider this bearish in the intermediate-term, it does remove a bit of the polish from the bullish case.
Above, I mentioned that OEX traders, who tend to be right more than wrong when it comes to market extremes, are betting against this rally to proceed much further. On the other hand, we have equity options traders, who tend to be wrong more than they are right at the extremes, betting that the rally will continue unabated. The 10-day average of the equity put/call ratio, minus QQQ options, hit a new low on Friday, as the chart below shows.
This indicator has a quite good record at calling the extremes, when considered in a contrarian manner. That is, when put volume skyrockets higher compared to call volume (thus driving the blue line higher), the market has soon found a low. A notable exception is last summer, when this indicator would have had you buying way too early. On the other hand, when call volume overtakes put volume to a great extent, driving the indicator lower, then at least a short-term market peak has followed without exception. The history on this indicator is short, barely two years, so we can’t place too much weight on its readings. But what we do see is that equity options traders, normally wrong to a fault, are betting aggressively that the rally will continue. That’s often a sign that it will do the exact opposite.
In the Rydex mutual fund complex, traders have been getting very aggressive in their asset movements for the first time since late March. The Beta Chase Index, which measures the flow of funds among high-beta (speculative) and low-beta (safe, or at least a low correlation to broader market moves) Rydex mutual funds, hit a very high reading of 5.0 on Friday, as the chart below illustrates.
Very roughly, a reading of 5.0 means that the highest-beta funds that Rydex offers are showing relative strength in their asset flows about 5 times greater than the lowest-beta funds. This tells us that these traders are “chasing beta”, meaning they are attempting to get the most bang for their buck by shifting their money into the funds that should benefit the most should the rally continue. If these traders were overly concerned about a correction, they would most likely back off these speculative funds and instead place their money in something with a lower beta. The fact that they are not suggests that they are comfortable – even complacent – with their outlook for continued upside. This is confirmed by the Rydex stochastic and RSI Spread indicators posted to the site as well. As we can see from the chart above, this type of complacency has lead to market weakness more often than not. However, we only have a few years of data here, so it’s relatively difficult to determine how these traders will react in a bull or trading-range type market.
Miscellaneous
The breadth of the market remains wildly overbought, by almost any measure I follow. I went over the advance/decline figures on Wednesday, so I’m not going to repeat myself here. Our daily cumulative TICK, which simply sums the closing NYSE TICK reading over the previous 10 days, reached a high of just under 6000 on Wednesday and Thursday. This level had only been reached three other times in the last five years – the market peak in July 1999, the peak in January 2001 (although the market ran higher by about 2% before rolling over) and the peak in March 2002. It’s not entirely surprising to see these kinds of sustained TICK readings considering the way the market has performed, but still it shows that it may be too much, too fast. History over the past five years would support that conclusion.
I’ve been asked several times about what to make of the VIX, since it has not been dropping while the market has been rising. This is unusual, as changes in the S&P 100 and changes in the VIX have had a correlation of -0.77 since 2000. This is quite high, and means that it is rare to see the VIX rise at the same time the S&P does. Even more unusual, even though the S&P is up more than 5% over the past 10 days, the VIX is higher now than it was then. During the life of the VIX, this has happened 19 other times. I could not find any kind of relationship between these occurrences and future market performance, so I can’t say whether this is bullish or bearish based on history. As far as recent instances go, I could only find two other ones since 2000 – late March 2000, which lead to a large drop over the next few weeks, and mid-October 2001, which lead to a choppy market.
Weight of the evidence
Going into this weekend, after seeing the reversal on Friday and the refusal of the VIX to drop during the last couple of weeks, I was expecting to see history prove out that both were bearish developments. After studying both, I cannot conclude that’s the case, as neither one has historically lead to any kind of consistent market performance, either up or down. About the only thing I feel comfortable stating with an acceptable degree of confidence is that if the market recovers right away next week, then there is a good chance Friday’s reversal session will not hold, and its high will be exceeded at some point during the week.
If we look at what the smart money is doing compared to the dumb money, the picture gets a little more clear. From what I can determine, the more sophisticated traders are not betting heavily against this rally across a multiple of trading vehicles, as they have most of the other rallies for the past few years. The one exception is OEX options traders, and even I have to cast some doubt as to the sophistication of those traders, knowing some of them personally. However, it’s difficult to argue against their record at calling market turns, which is impressive, and it’s now focused on the short side. As far as small traders go, or those most likely to be wrong, they are being quite aggressive in their assumptions that the rally will continue, as is outlined above. Obviously, this is a troubling development. It could be argued that is has been troubling for several weeks (and several percentage points), and the market has barely budged. That’s true to some extent, although we are now registering extremes that we hadn’t before.
I have been wrong in my outlook that the short side was the side more likely to make the most profit with the least risk over the past few weeks. This rally has gone much further, in a much shorter time frame, than I thought was probable. More signs exist now than have in quite some time that some type of rest is needed, so I continue to prefer the short side over long in all time frames, but as I said earlier this week, there is considerable evidence that we may, in fact, be seeing the emergence of a new market environment where higher prices are not so much of a struggle.
- 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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