Some Good Signs, But Still No Confluence
Thursday, July 8th, 2004 8:20pm EST
OEX Traders Coming Around
Bottom Line: The relatively good market timers who concentrate on the OEX have nearly reversed the bearish extremes they reached a month ago, at least by one measure, and that is a good sign.
In mid-June, I outlined a couple of developments regarding OEX options that I figured were bearish for the market, or at least were becoming potentially so (see here and here). With the decline we’ve seen over the past week, we’re beginning to see OEX traders turn tail somewhat and show more of a bullish inclination.
I’ve outlined many times why OEX traders should be considered “smart” money, or at least infinitely better market timers than regular equity options traders. The put/call ratio on the OEX index should be considered in a non-contrary manner, meaning high levels tend to be bearish for the market, while low levels tend to be bullish (this is precisely opposite of the other put/call ratios followed on the site). On a 10-day moving average basis, the OEX put/call ratio had become extremely high by early June, which as I said was not a good sign. Now, however, after six straight days of the OEX put/call ratio registering readings below 1.0, that same 10-day average has declined enough to put it in the opposite extreme. Just as the readings in early June were an indication that these relatively good market timers were becoming quite bearish, the readings now imply that these same traders are considering the market a better bet on the long side.
This is the 13th time since 1997 that the OEX p/c ratio registered six consecutive readings below 1.0, and its record over the ensuing couple of weeks is impressive. 10 days after, the S&P 500 cash index was higher 11 out of 12 times, sporting an average return of 2.0%. After 30 days, we still saw a 92% success rate, and the average return nearly doubled to 3.9%. By the way, these figures include several instances from 2000 – 2002, so the positive results were not due solely to having occurred during bull phases.
One of my preferred ways of viewing the OEX put/call data is in relation to the equity put/call ratio. On the site, we track the OEX – Equity Put/Call Spread, which is simply the 10-day average of the OEX put/call ratio minus the 10-day average of the equity put/call ratio. When the spread is high, it tells us that OEX traders have been concentrating on puts and/or equity options traders have been concentrating on calls. That is normally bearish. On the other hand, a low spread tells us that OEX traders generally are bullish and/or equity traders are bearish – typically a bullish combination.
The chart below shows this put/call spread for the past few years. The red dots on the S&P chart highlight those times the spread was exceptionally high, while the green dots highlight times the spread was extremely low.
We can see from the chart that high spreads have indeed tended to precede a market that struggled to find sustained upside, while low spreads more often than not were good spots to be concentrating on long positions. There were a few failures, of course, as with anything, but overall the record is impressive and should be respected.
Currently, the spread is very low due to a combination of a low OEX p/c ratio and a relatively high equity p/c ratio. As we can see from the green dots on the chart above, such a low spread has most often seen limited downside going forward. I would like to see the spread bottom out before considering it an outright bullish indication, but we’re very close to a point that this data will be firmly in the bulls’ camp.
Popping the Balloon
Bottom Line: Rydex traders, who were so extremely aggressive as early as last week, have had a reality check the past few days, and are beginning to swing to the other side. There is still more excess to be wrung out, but what we’re seeing is the beginning of a positive development.
Last Thursday (click here), I discussed how aggressive Rydex traders were becoming with their assets on the long side, and that it normally pays to take the other side of those trades. At the time, our Rydex Beta Chase Index, which measures these traders’ relative preference for high-beta (risky) funds over low-beta (safe) funds, recorded a reading around 18, essentially meaning that these traders were 18 times more willing to invest in a risky fund than a safe fund. That type of speculation was a concern, and it’s not a surprise that it was a concern for a good reason.
Since Rydex does not release their asset data until late each evening, or early the next morning, we don’t yet know how these traders reacted to today’s poor market. But as of yesterday, quite a bit of the air was let out of their speculative balloons.
As of yesterday, the Beta Chase Index was just over 1.0, telling us that these traders were not favoring high-beta funds significantly over low-beta funds. In fact, you can even make the argument that they are now under-weighting the risky funds. Over the life of this indicator, the median value has been about 1.5, so the current reading is below average.
I certainly wouldn’t say that Rydex traders are now excessively pessimistic – in fact, they seem to be far from it. But they have at least begun to swing around from the rampant speculation we saw as early as last week, and that is a positive sign. Now we need to see things like the Enthusiasm Index and Stochastic to register some low readings, and then we can say that these wrong-way traders are pressing the short side.
Conclusion
Since late January, my contention has been that we would see a prolonged period of a trading-range market, one in which using oscillators and buying oversold conditions while selling overbought ones would outperform trend-following, breakout-type strategies. I see nothing so far to change that view, and I continue to believe that once we see a confluence of oversold readings from the current decline, it will once again be time to shift back to the long side. We’re starting to see a few of those signs pop up now, but we certainly don’t have a confluence such as we had in March or May. We could of course rebound at any moment, but it likely won’t pay to become aggressive until more measures line up.
In the short-term, a few of our intraday measures are back to oversold status, particularly on the Nasdaq (again). They are not exactly extreme, but any further decline in those shares should quickly put the measures into “stretched” territory, increasing the likelihood of a snapback rally. The closer we come to the bottom of the range, particularly when accompanied by these types of readings, the less inclined I become to attempt pressing any short-side bets.
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.
© 2004 Sundial Capital Research, Inc. All Rights Reserved.