The Most Difficult Inflection Point All Year
Thursday, August 5th, 2004 8:45pm EST
Pressure Cooker
Bottom Line: The Down Pressure reading on the Nasdaq 100 hit an extremely high level today. Historically speaking, this type of reading has meant that early weakness is most often reversed the next day.
Our Down Pressure gauges for the S&P 500 and Nasdaq 100 (NDX) look at the number of points lost for each of the components in each index as well as the volume flows into each. It then averages those two figures. Today on the NDX, for example, I show that 94 of the components declined on the day. The 6 gainers added a total of just over 2 points, while the losers lost a total of about 67 points. Therefore, 97% of all the points gained or lost on the day were lost. The volume flows were equally bad, so the average between points lost and down volume for that index ended up being 97%, the 7th-highest reading we’ve seen so far this year.
The Down Pressure indicators as posted to the site are actually 3-day moving averages of these daily figures. The 3-day average for the NDX is now sitting at 80%, one of the worst showings so far in 2004. The chart below shows the data for this year, with other readings matching or exceeding our current one highlighted in green.
Since July 2002, whenever we saw a daily Down Pressure reading of 95% or greater, QQQ (the Nasdaq 100 exchange-traded fund) gapped up the next day 74% of the time (23 out of 31 occurrences). Buying the open and selling at the close would have resulted in a profit 71% of the time, for an average return of 0.9%, with the average winner more than twice as large as the average loser. There were 7 times QQQ gapped down at the open. Buying that open and selling at the close resulted in a profit 6 of 7 times, with an average return of 1.7%.
I also checked those times the market was down large the day before the employment report over the past couple of years. QQQ gapped down the next day 50% of the time and closed lower 3 out of 8 times. The returns were so insignificant, however, and there were so few instances, that it is impossible to draw any conclusions from including that as an input.
The day after a Down Pressure reading of 95% or greater, QQQ closed higher 81% of the time. Combined with the stats mentioned above, it is clear that over the past two years, early weakness after such broad selling pressure was normally short-lived. Gap down openings in particular were traps every time but once, suggesting that should we see weakness before the open tomorrow, most likely due to a weak employment report, then history suggests it would be imprudent to press the short side.
Be Wary of One Day’s Option Volume
Bottom Line: Despite today’s steep declines, the most often-cited put/call ratio actually declined. If this keeps up, it would be unmistakably bearish, but one day’s reading is not necessarily a bad sign.
For the first time in over a year, the total put/call ratio from the Chicago Board Options Exchange (CBOE) declined on a day the S&P lost at least 1.5%. This will undoubtedly be trotted out as a sign of complacency among investors, however I would strongly caution against subscribing to that theory. While I do find value in put/call ratios when they are either very high or very low over a sustained number of days, single-day readings can be very misleading.
It is rare to see this put/call ratio decline when the broader market suffers such a large decline. During the past 9 years, there have been 242 days where the S&P 500 declined 1.5% or more in a single session. On only 65 days, or 27% of the time, did the put/call ratio also decline. Normally we see traders pick up their put option activity, either buying or selling, on very large down days. But according to history, it really doesn’t mean anything at all that the ratio declined today.
The chart below shows how the S&P fared the given number of days after the index dropped at least 1.5% in a single session, separated by whether the put/call ratio declined or rose on the day.
Not much of a difference there. In fact, the S&P was actually higher more often when the put/call ratio declined than when it rose. The average return was higher, too.
Don’t get me wrong – despite the figures above, I do not think a drop in the put/call ratio on a day like today is a good thing. I would much prefer to see a few days with more puts traded than calls. I would also very much like to see our R.O.B.O. put/call ratio spike higher this week, showing a substantial increase in put buying from the smallest of options traders. But I think it’s important to separate fact from fiction, and the fiction is that a single day’s decline in the put/call ratio on a bad day in the market has not at all been a bad omen going forward.
Conclusion
The data above is all very short-term. Most of the other positives that can be noted are also short-term – our indicator score, at 71%, is giving its highest reading since April as of today’s close. In fact, other than a few readings in March and April, we’d have to go back to September 2002 to see higher readings. These measures are not meant to indicate intermediate-term exhaustion points, and while they do pinpoint longer-term turning points occasionally, they are most useful as indications that buying or selling pressure is overdone. A high score such as we’re seeing tonight does not mean we will turn around immediately and head higher – rather, it suggests that that chances are high that we have seen the major thrust down for the time being, and the selling pressure should lessen over the next few days. If we get a large gap down tomorrow morning (say 10 points or so on the NDX), we should see a quick snapback, but that would apply to only the shortest-term of traders.
I’ve been using the 1075 level on the S&P as a kind of mental “stop” on a moderately bullish posture. I’ve felt over the past week or so that the downside should be limited, but a break of that obvious support level calls that into question. I’ve noted how we’re at the most difficult juncture so far this year, and today’s action reinforces that. I continue to believe that we are not at a point that warrants aggression in either direction.
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.