Not the Time to Chase Them Higher
Sunday, October 3rd, 2004 9:30am EST
Nasdaq Extreme
Bottom Line: Our shortest-term model for the Nasdaq is at its most-stretched point since 2002.
One of the charts that we update intraday is the STEM.MR model for the Nasdaq. The model is calculated throughout the day by taking readings from several sentiment-related measures related to technology shares, such as the VXN, TICK and TRIN. By Friday afternoon the model dipped to 11%, which essentially means that the average input to the model was showing optimism that was greater than 89% of all other readings over the prior six months. This type of confluence among the inputs is rare – in fact, Friday’s model reading tied the lowest seen in the past two years.
Normally such an extreme reading can be considered in a contrary manner, suggesting we should see weakness ahead. However, if we are beginning a new intermediate-term trend higher, the Nasdaq will likely power higher in spite of overbought conditions. Perhaps the best course is to look at all other instances of the model dipping to an extreme level. The five charts below highlight the action in the Nasdaq 100 after extreme model readings since tech bottomed in October 2002. The red bars highlight the day the model hit its extreme.
The type of activity after these readings is the main reason I suggested we should see a labored move higher in an intraday update on Friday. After four of the five occurrences, the NDX managed at least one more day of gains before declining. In two of the instances, the NDX was able to string together multiple up days.
However, and I think this is important, in every one of the cases the NDX fell back to the close of the day of the model extreme within a week. While it did not necessarily mark a short-term top with consistency, such an extreme in the model suggested that if we were going to try to play the long side, we had better be short-term oriented and very nimble with our positions. I see no reason to believe this occurrence will behave any differently.
Put Volume Cannot Be Explained Away
Bottom Line: While there are many good-sounding reasons to discount the heavy put volume we have been seeing, they do not seem to hold any water. It appears as though there is a lot of protection built in now, which has historically been a long-term buy signal.
One of the truly remarkable hallmarks of the rally off the August lows is the consistent display of distrust and apathy shown by traders for much of the time. I have recently shown examples of this via Rydex mutual fund asset levels, but another glaring example comes from the world of options trading.
If you have been following the put/call ratios that are posted to the site, you have seen that for the most part, traders have not picked up their call activity since August like they had the previous rallies this year. In fact, on a longer-term time frame, we have seen an extraordinary amount of put volume in relation to calls this year, despite the broader market treading water and not declining heavily.
One of the better displays of this is shown in the chart below. This graph encompasses equity options trading data from all the exchanges, not just the traditional Chicago Board Options Exchange. On the chart, the blue line is a 30-day moving average of the all-exchange equity put/call ratio, and the red line is a 30-day average of the open interest ratio.
By looking at the blue line, we can see that traders were concentrating heavily on puts for an extended time in July and October 2002 and again in February/March 2003. By June 2003, we were seeing a relatively large shift as calls became more and more favored. That reached a fever pitch by early this year, as the put/call ratio reached a territory it hadn’t seen in years. However, the trading range we have seen so far in 2004 has prompted traders to concentrate on puts once again, to a degree not seen since the Spring of 2003.
The steadily rising red line shows us that all that put volume has not been going to close out existing contracts. In fact, put open interest has been rising faster than call open interest, meaning that traders have been opening more and more contracts as time goes on. As I’ve discussed before, however, just because put volume is high doesn’t mean traders are placing bearish bets – they could be selling these puts to open, which in fact would be a relatively bullish bet that prices are not about to decline. Let’s see if that’s the case:
The chart above shows us whether traders are buying puts to open (a bearish bet) or selling them to open (a bullish bet). We can clearly see that since mid-2002, traders have been buying more than selling, which tells us that the traditional interpretation of the volume figures should be correct.
This long-term preference for puts can perhaps best be seen by the chart below.
Over the past six months, put volume has averaged nearly 90% of call volume. This type of sustained trend in put volume is matched only by the readings seen in August 1994 and October 2002. Both instances, of course, were excellent times to be accumulating stocks.
Something else unusual is that the put/call ratio on the CBOE closed just below 1.0 on Friday despite the impressive rally. In fact, this is the first time since February 2003 that the put/call ratio was so high on a day the indexes managed such substantial gains. Since 1995, there have only been five other days when the total put/call ratio was above .95 on a day the S&P closed at least 1.5% higher. Interestingly, 10 days later the index was lower 4 out of the 5 times, with an average return of -1.4%. However, 90 days later it was higher all 5 times, and sported an average gain of 7.5%.
What all this means is that traders have been concentrating very heavily on puts over the past couple of months. This put volume cannot be attributed to traders closing out positions, and it cannot be attributed solely to traders selling puts to open. So we have very solid evidence that there is a mindset among options traders that prices will decline, and they are consistently betting that way. This tells us that there is likely a floor underneath the market. All of those put contracts that have been bought and are still outstanding serves as a kind of insurance to those who bought them. They can buy stock, knowing that to some degree they are protected by the put contracts they own. You will likely read many arguments against reading too much into the recent high put/call ratios, but I don’t believe they have merit – there is a lot of insurance beneath this market, and that should help keep prices stable to higher.
Conclusion
Last week I discussed a couple of measures that suggested apathy towards semiconductor shares was high. Even after another 7% rally in the group since then, not much has changed according to the measures I showed. Rydex assets continue to hover around their same levels in the Electronics fund, and traders have not been abandoning the exchange-traded fund in favor of individual shares. Both indicators suggest that it is probably not a wise move to try to step in front of that uptrend at the moment.
With implied volatility measures once again hitting new lows (or very close to it), and many of our short-term measures hitting extremes, it is tempting to want to bet against rising prices. Out of the 7 times the VIX hit a new yearly low this year, the S&P was lower 10 days later 6 of those times. But as the STEM.MR Nasdaq charts above illustrate, that type of activity does not necessarily mark the exact top. Combined with positive seasonality in the beginning of most Octobers, it seems as though there is more room to go on the upside before we take another breather. I do think that if we do rally early next week, at some point within a week or so, we will be re-visiting Friday’s prices, so even though there may be more to go on the upside, I don’t think it’s a good idea to chase strength here except for very short-term and nimble traders.
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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