Rally is Gaining Acceptance (short-term bad, long-term good)
Tuesday, August 24th, 2004 9:50pm EST
Odd Lot Optimism
Bottom Line: Odd lot orders have been skewed largely in favor of purchases over the past week, with a drop-off in short sales, suggesting these wrong-way traders are betting on more upside.
Over the last couple of weeks, I have touched on the excessive pessimism being displayed by odd lot traders, those who enter orders for fewer than 100 shares of stock at a time. For instance, on August 6th these traders set a new all-time record for short sales, and by early the next week (as the market was finding a low), the measures that we post to the site had reached “extreme pessimism” territory.
The rally since that time has predictably changed their tune to a large degree. As we noted in the Daily Overview Summary on Monday night, odd lotters have apparently now bought in to the idea of a longer-term low. First, let’s look at those short sales once again:
The chart above is a 5-day average of total odd lot short sales (in millions of shares). The green and red dots highlight the relative extremes seen so far this year, and they have coincided quite well with at least short-term turning points in the S&P 500. Over the past five days, short sales have averaged about 820,000 shares daily, about what we saw near the peaks in January, April and June.
We can also see this small-trader optimism in another measure we follow, the Odd Lot Purchase Percentage. This is simply the percentage of total odd lot purchases and sales that are purchases. The higher the ratio, the more buying they are doing; the lower the ratio, the less buying.
Once again, we can see that on a 5-day average, these traders have been net buyers of stock to a degree last seen at other peaks so far this year. This is in stark contrast to what was seen just a few short weeks ago, as the purchase percentage was hitting new lows.
Several subscribers have brought up the fact that the NYSE has changed the rules surrounding odd lot orders, giving some incentive for professional traders to break up their orders into odd lots, thus circumventing existing rules for larger orders. This type of manipulation is certainly possible, and I would not doubt that it exists to some degree, but so far the volume patterns have not changed significantly, and total odd lot volume is still miniscule compared to total volume, making it hard to see how it could make much, if any, difference to a professional trader’s bottom line. Most importantly, these odd lot trading patterns continue to be a relatively good contrary indicator. Until these things change, I think it’s safe to say that these orders are still a good measure of small, emotional trading by wrong-way traders.
Expectations vs. Reality
Bottom Line: Divergences between implied volatility in options and the price performance of underlying indexes can give us clues as to investor expectations. There is a current divergence in NDX options which has bearish connotations.
I’m often asked why I don’t discuss the VIX and VXN very much in these comments. Those implied volatility measures are a staple of most quote programs, and are discussed frequently by even casual observers of market sentiment. The basic argument is that if these measures are low, then investors are not pricing in the probability of severe price swings, which is a measure of complacency and often precedes market declines; vice-versa for when the measures are giving high readings.
The main reason I don’t talk about those indicators very often is because they usually don’t give us much new information that is not readily apparent from just looking at a chart of the indexes themselves. So far this year, the correlation between the NDX and the VXN has been extremely high – the VXN closed in the opposite direction of the NDX close on 78% of the days. By just inverting the chart of the NDX, you would get an almost carbon-copy of the chart of the VXN.
However, every once in a while the two will diverge, and that’s an instance when I think these measures can gain some utility. Take a look at the chart of the NDX and VXN below, with three divergences that are notable.
At point A, the NDX made a slightly lower low, yet the implied volatility on NDX options never spiked higher (point B) – in fact, it remained well below the peak seen earlier in February. This was a sign that investors were not bidding up the price of puts, a bearish indication that ultimately resulted in another leg lower in the NDX.
In May (point C), the Nasdaq 100 tested – and held – the lows from March, yet the VXN spiked well above what was seen then. Unlike the previous example, this was telling us that traders feared the worst, and expected a significant break of those previous lows. Their fears obviously were not warranted (at least in hindsight) as the NDX went on to rally well.
The current situation, point E, is something a little different. Here, the NDX is sitting about 40 points below where it was at its short-term top in late July. Yet the VXN is more than a point below its late-July low (point F), which is suggesting that traders believe the worst is behind us for now and they do not feel a need to scramble for the protection of put options.
This latest divergence is not as egregious as the March/May example, but I do think it’s notable enough to mention, and it bears close watching. If the VXN continues its free-fall while prices consolidate, it should increase the chances that we will see at least a short-term setback.
Conclusion
As is often the case after we see a sharp market move, there are a plethora of mixed signals out there. Seemingly excessive optimism from wrong-way odd lot traders suggests we need a breather here. Also, despite a rather weak up day on the Nasdaq yesterday, Rydex traders shifted $54 million out of the leveraged bearish Venture fund and put $40 million into the leveraged bullish Velocity fund. That was an extremely large shift for a mild up day on that index and suggests that these traders too are beginning to believe in the rally (which is normally not a good sign).
On the other hand, the International Securities Exchange reported that today traders bought only 107 calls per 100 puts, a low number that, over the past year, has only been matched in early August 2003 and mid May 2004 - both instances leading to good gains over the ensuing weeks. Even including a couple of bad signals in January and February 2003, over the history of this data the 30-day return in the S&P 500 after such displays of tepid call buying was over 3% (about triple a random 30-day return during the period) and the index was positive 76% of the time.
The two topics discussed tonight are both short-term negatives, and I think they are compelling enough to suggest that being aggressively long is probably not a good bet, at least for short-term traders. At best we should see minimal upside progress over the coming days, and at worst a challenge of the recent lows, so the risk/reward does not seem to be especially attractive. On a long-term time frame, I continue to believe that it is likely we have seen another intermediate-term low, and should we actually get a decline that approaches last week’s low, it should serve to set up good opportunities from the long side.
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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