Short-term Edge Remains Elusive
Tuesday, June 15th, 2004 8:30pm EST
Big Bond Moves
Bottom Line: Large one-day rallies in Treasury Bonds have not had a consistent impact on the performance of the equity markets, besides perhaps being slightly positive in the short-term.
Today we saw an outsized move in long-dated Treasury Bonds, as the 30-year Bond gained well over 2 full points, knocking 2.8% off its yield (that would be equivalent to about a 290 point rally in the Dow Jones Industrial Average). That large of a decline in yield is close to being in the top 20 since 1977, so we’re talking about a very large move here.
One of the most obvious questions would be “What does it mean going forward?”. It turns out not a whole lot, at least not when we look at historical moves. Unlike many of the studies we look at regarding sentiment readings or breadth measurements, bond moves have different impacts on the stock market depending on where we are in the economic cycle. Sometimes a bond rally is good, sometimes it’s bad, and so it is difficult (if not impossible) to draw meaningful conclusions from today based on comparisons to what happened 10, 15 or 20 years ago.
Still, since it is a curiosity if nothing else, the chart below shows how the S&P 500 performed after other large one-day Bond rallies. By “large”, I included all declines in yield of 2.5% or greater, of which there were 38 occurrences. The table shows the relative out- or under-performance of the S&P after large bond rallies compared to an average period.
From the chart, we can see that 10 days after bonds had a large one-day jump, the S&P showed an average return that was nearly 1.5% greater than a random 10-day period during that time. Also, it was higher 10% of the time greater than an average period (that is to say, it was higher 68% of the time after large bond rallies, compared to 58% of the time on average – a “premium” of 10%).
After 30 days, even though the S&P still showed an average return greater than average, the percentage of time it was positive was nearly identical to any other period. The one exception is after 120 days (about six months later), when the S&P was positive 62% of the time after large bond rallies, compared to 71% of the time during an average period, showing some under-performance.
Looking at the last ten occurrences, which takes us back to 1989, the S&P was higher after 5 days every time but once, with an average return of +1.8%. After 90 days, the S&P was again only down one time out of the 10, and the average return climbed to a hefty +9.2%. After one year, we once again see only one negative return, and overall the average was +14.6%.
While it might be said that equities tend to out-perform a random period after large one-day bond rallies, at least in the short-term, the edge is not significant enough to suggest that it is a reason unto itself to be bullish. Recent history is more positive than that seen over the study period as a whole, but again it is difficult to know if traders will interpret this kind of move in a similar vein.
Shifting Sands in OEX Land
Bottom Line: OEX traders are reversing the bullish positions put on in mid-May, as the 21-day average of the put/call ratio is soaring. While it is not quite as high as it was near other peaks, it is close to sounding an alarm bell (bearish).
Back in mid-May, I showed a current chart of something I call the OEX Determination Index. Recall that the index is created by observing how much put volume as opposed to call volume is going to create new positions. By looking at the data this way, we can get an idea of how determined these traders are to be exposed to the upside or downside. At the time, I pointed out that while the index was not as extreme as it had been at prior major lows, it was close. This told us that OEX traders, who tend to be admirable market timers, were betting fairly heavily on a rally. As I’ve stated ad nauseam, OEX traders in general should NOT be viewed as a contrary indicator.
While the rally over the past few weeks has worn on, these traders have increased their interest in puts. The 21-day moving average of the OEX put/call ratio, shown below, is now approaching the upper end of its usual trading range, last seen in February.
Since 1997, high readings in the OEX put/call ratio have generally coincided with future market weakness, while low readings have often preceded the opposite. For example, 20 days after the 21-day average peaked at a level of 1.4 or above, the S&P 500 was higher only 27% of the time (3 out of 11 occurrences), with an average return of -1.8%. 120 days later, the S&P was higher 4 out of 10 times, and the average return was -1.4%. Contrast that to times when the ratio was forming a low under 1.0. 20 days after those occurrences, the S&P was higher 89% of the time (8 out of 9), and the average return was a very respectable 5.8%. 120 days later, it was higher 78% of the time, and the average return was 8.0%. Clearly, there is a wide chasm in future S&P performance between those times when the OEX put/call ratio was low (bullish for the market) and when it was high (bearish for the market).
The current level of the 21-day average is not quite as high as it was earlier this year, or as high as some of the previous peaks over the past few years. However, it is rising quickly and it should be monitored.
Conclusion
Today’s closing breadth readings were very strong, with close to 1,800 more issues closing up on the day than down. Going back over the past year, I looked to see how often that type of activity was reversed early the next day. Looking at the advance/decline figure at 3:30 pm EST (a half-hour before closing), any time there were at least 1,000 more advancing issues than declining issues, the S&P went on to lose .06 points in the last half hour, with exactly 50% of the occurrences being positive. However, by the end of the first ½ hour of the next day’s trading, the S&P lost 0.70 points on average, with only 38% of the instances being positive. By the end of the first hour, the average loss expands to just over 1 full point, with 35% of the instances positive. That tells us that when breadth has been very strong approaching the last ½ hour of trading, often the market reversed course early the next trading day.
If we look at the opposite end of the spectrum, very poor breadth, a similar pattern emerges. When the a/d figure was -1,000 or less at 3:30pm EST, then the S&P went on to lose 0.26 points going into the close, but 52% of the instances were positive. Most noticeably, however, is the fact that by the end of the first ½ hour of trading the next day, the S&P was higher 74% of the time, with an average gain of nearly 2 full points. By the end of the first hour, the market often reversed again (resuming the decline from the previous day), as the S&P lost about a point during the second ½ hour of trading, and about half of the instances were positive.
There is a very clear distinction between how the market reacts after very positive days and very negative days, at least in the extreme short-term, and it suggests that we may see some weakness early tomorrow. Our shortest-term measures are mostly back to neutral, after having their oversold conditions alleviated by this morning’s rally. The STEM model, which I mentioned as a negative this weekend, didn’t budge today and remains near the lower end of its trading range (though it’s out of “danger” territory). Other than the figures quoted above, I don’t seen a sharp edge in either direction.
Longer-term, I will just repeat what I said this weekend as it continues to be my view…May saw an important intermediate-term low, declines that put us into an oversold situation should be viewed as opportunities to add or initiate long exposure, we should see modest gains for the year, but the best strategy will most likely take advantage of oscillating indicators (selling overbought conditions and buying oversold ones) rather than breakout strategies. We are holding the modest long exposure in the model portfolio that we initiated at just under 109 in SPY, but will likely trim that if we see more of a rally.
Jason Goepfert
President and CEO
Sundial Capital Research, Inc.
Disclosure: no positions
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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