Traders Looking (too) Confident

Bottom Line: Small traders have been buying on balance over the past month, historically a bad sign for the market going forward.

On August 17^th, I discussed something that I called (somewhat tongue-in-cheek) an “infallible” buy signal. While that data was a good tip-off that we were in store for more of a rally, we now have something that is close to giving us the same level of confidence in the other direction.

I’ve mentioned odd-lot trading activity a few times over the past couple of months, and we have a couple of the indicators posted daily to the site. Recall that odd-lot trades are those for fewer than 100 shares at a time, and are a reflection of small-trader sentiment. As usual, this is best interpreted in a contrary manner, with excessive optimism from these traders most often coinciding with market highs and excessive pessimism with market lows.

Over the past 21 days (the length of an average month), odd lot traders have concentrated more than 56% of their volume on the buy side. While 56% of the total doesn’t sound like much, historically it is extremely high. In fact, since 1970, there have only been 4 distinct occurrences when a prior month has seen such an over-balance of buying by these traders. The table below outlines the performance in the S&P 500 the given number of days after those occurrences.

S&P 500 Performance After Odd-Lot Buying Sprees 21-Day Average, 1970 - 2004
Date	Odd Lot Purch %	S&P 500 Performance
Date	Odd Lot Purch %	5 Days Later	10 Days Later	20 Days Later	30 Days Later
06/01/1970	56%	-2.0%	-4.2%	-6.4%	-4.4%
06/15/2000	56%	-1.8%	-2.5%	2.1%	-3.2%
11/09/2000	56%	-2.0%	-3.7%	-1.4%	-5.1%
06/25/2004	56%	-0.8%	-1.8%	-4.4%	-6.1%

Average Return		-1.6%	-3.0%	-2.5%	-4.7%
# Positive		0	0	1	0

It’s often easier to see these types of indicators in chart form, so following is a graph of the 21-day average of the purchase percentage since 2000.

We can see from the chart that after periods of lopsided odd lot selling, when the 21-day average dropped below 45%, the market tended to perform well afterwards. In fact, since 2000, when the average first declined below 45%, the S&P was higher after 30 days all six times, with an average return of 3.2%. This obviously contrasts with those times the purchase percentage was very high as we saw from the table above, when the S&P was lower after 30 days every time and the average return was -4.7%.

The basis of contrary investing is to find a group of traders who do poorly at market timing, and when they are mostly in agreement about market direction, you take the other side of the trade. It is not a perfect strategy of course, since sometimes just by chance those traders are right, and sometimes we misjudge when an extreme is reached (or not reached). Looking at the data above, in a way that makes sense to me, it appears as though we have a group of traders who are consistently wrong, and they are about as much in agreement now as they have been at any other time in the past 34 years. Their opinion is that the market will continue higher, but from a study of their performance history, it seems more likely that their opinion will not be fulfilled.

There isn’t a whole lot that’s new to go over tonight. In the last comment, I noted that if we saw another couple of days where traders shun ETFs in favor of trading individual equities, then our SPY Liquidity Premium would likely enter extreme territory. That indeed occurred, with the Premium dropping to -20% today on a 10-day moving average basis. While these ETFs have only been around for a few years, whenever our Premium dropped below -20%, the S&P 500 was lower after 90 days for 47 out of the 57 days (for an 83% “success” rate), and the average return was -3.8%. I don’t think there’s anything magical about this indicator, or this level, but I do find it troublesome that traders have no apparent desire to use the exchange-traded funds (short-selling ability, liquidity) in lieu of individual equities.

My thoughts last time were that we if we could see a rally into expiration day, it should make the short side considerably more attractive, particularly if it coincided with overbought readings from more of our measures. While Wednesday’s decline threw a small wrench into the gears, overall the picture seems to be intact. We are seeing groups of traders who tend to be wrong at the extremes buying heavily, and there is a notable sense of comfort among many others. That suggests to me that the traditional weakness post option expiration is likely to continue for this cycle as well, and I anticipate we will see a deeper correction over the coming days/weeks than we have seen so far in this rally.

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.