A Different Look at Volatility
Wednesday, May 12th, 2004 7:45pm EST
Breadth Volatility
Bottom Line: A look at the volatility in breadth on the NYSE shows we are experiencing a rare market phenomenon that has been matched only a few other times in 40 years – each of which preceded a good intermediate-term rally.
One of the hallmarks of the past couple of weeks has been the sharp reversals in breadth on the NYSE. By “breadth”, I’m simply referring to the number of stocks that close higher than the day before minus those that close lower. We have seen some very large numbers, mostly negative, but very volatile. As one way to view this volatility in breadth, I looked at the standard deviation of the breadth figures over a 10-day period and compared that to the total number of issues traded on the exchange. Over the past 10 days, the standard deviation of the advance/decline figure has been 1631. This means that 68% of all the readings should have been within 1631 issues of the average. The absolute number isn’t all that important – what may be important is the fact that when we divide 1631 into 3479 total issues traded on the exchange, we come up with a breadth volatility figure of 47%. This compares to 13% near the peak in January, when the number of advancing and declining issues remained very stable over a 10-day period.
So is this good or bad? Well, each moment in the market is unique, but if history is any guide at all, then this type of violence in breadth is very positive in the intermediate-term. We only have a few other comparable instances on which to base our opinion, and there was often some short-term pain, but looking out 3 months or more, the market performed extremely well. In fact, out of the 34 days that showed a breadth volatility reading equal to or exceeding the current one, the S&P was higher after 90 days 34 times (a 100% success ratio). I’m always leery of anything that suggests something is 100%, and by no means do I intend to suggest that we will for sure be higher 90 days from today, but it is a compelling figure.
The series of charts below show each of the distinct occurrences, with the first day of the extreme breadth volatility reading highlighted by the dotted vertical lines, along with the volatility figure and the return in the S&P 90 days later.
After the 34 days that showed such extreme volatility in the breadth readings, the S&P was an average of 10% higher after 90 days, and again every one was positive. One year later, each of them was still positive, and the average return climbed to a very respectable 17.5%. Certainly the arguments can be made that the breadth figures are skewed by non-operating companies, or that decimalization has complicated historical comparisons, and I believe each has some merit. However, I don’t think either one significantly changes the basic idea that we have experienced some violent changes in breadth over the past couple of weeks, and that has historically been a long-term positive sign.
Option Dichotomy
Bottom Line: Equity option traders have been concentrating heavily on puts, while OEX index option traders have been focusing on calls. Such a divergence between the two has been seen only two other times – both preceding excellent rallies.
As I alluded to in an intraday note this morning, for only the second time in its history, the total put/call ratio (including both equity and index options) from the Chicago Board Options Exchange closed above 1.0 for the past 5 days. The first time occurred on September 20th, 2002. One other time it closed above 1.0 for four days in a row, and that was just about two months ago on March 15th. Neither one of those occurrences marked the exact low, but the market did follow a somewhat similar pattern after each of them.
The green dots on the charts highlight the days the put/call ratio was above 1.0 for the fourth consecutive day. After each of them, the market chopped around in the short-term, then made a dive lower before putting in the final low.
Looking a bit deeper into these ratios, we can see that the equity p/c ratio is headed higher and is in fact now quite extreme, while the OEX p/c ratio is headed in the other direction and is also quite extreme. You may recall that I consider the put/call ratio on the OEX (S&P 100) index in a non-contrary manner – meaning that high p/c ratios tend to precede a market decline while low p/c ratios tend to precede a market low. The OEX p/c ratio is not as consistent a non-contrary indicator as the equity p/c ratio is a contrary indicator, but historically these traders have been fairly decent market timers.
I post a chart to the site each day which plots the spread between these two put/call ratios on a 10-day moving average basis. When the spread is very high, it means that the OEX p/c ratio is high while the equity p/c ratio is low (and should be bearish for the market going forward). When the spread is very low, it means that the OEX ratio is low and the equity ratio is high (and we should see the market rise afterwards). Currently, this spread is extremely low – so low, in fact, that it has approached this level only two other times since 1997, highlighted by the green arrows below.
Conclusion
In a note on Monday and again in intraday comments today, I highlighted many of the extremes we’ve seen over the past week. Not only has breadth been historically weak, but we’re now getting some confirmation of this weakness from our more “pure” sentiment measures. I’ve been approaching this market with the attitude that we saw an intermediate-term low in March, and besides a slight and temporary undercut of those levels, we should not see appreciably lower prices. The action we’ve seen this week confirms that to me, and I would now be a more aggressive buyer on any further weakness for longer-term traders. As we saw with the put/call ratio examples above, we may not have seen the exact low for this move, but the historical precedent is very strong on several fronts that we should see significantly higher prices a few months from now.
On a short-term time frame, many of our shortest-term measures relieved some of their extreme conditions with the afternoon rally, but our models and composite indicator score are still very oversold. Combined with today’s reversal, we should see continued follow-through, and I prefer to trade from the long side as long as that is the case.
Jason Goepfert
President and CEO
Sundial Capital Research, Inc.
Disclosure: long Nasdaq futures
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.
© 2004 Sundial Capital Research, Inc. All Rights Reserved.