Now We're Getting Somewhere

Bottom Line: The broader market could not rally in spite of extremely heavy negative TICKS on Wednesday. Counter-intuitively, that has actually been a very bullish pattern over the past six years.

Yesterday, for the first time in 55 days, we saw a TICK reading on the NYSE that hit -1000. Recall that the TICK is a snapshot of a moment in time that shows how many stocks on the NYSE last traded on an up-tick minus those that last traded on a down-tick. A reading of -1000 means that 1000 more issues were trending down at that second than were trending up. Such a high negative number is quite unusual – it only happens about 15 to 20 times each year – and typically it is a sign either of a sell program hitting the market, or a climax of sellers pressing the “get me out” button at the same time.

Since we’ve gone nearly three months without seeing such a high negative reading, there is a chance that yesterday’s reading is giving a hint that the character of the market is changing, and we are due for a spell of more severe selling. Since 2002 (about as far back as we can go without the range of the TICK being distorted), there were two other streaks that went as long as this one did. The first ended on 01/27/03 and the other ended on 07/17/03. While two occurrences is nothing from which to base a decision, it’s interesting to note that the market put in at least a short-term low 13 days after the first instance and 14 days after the second.

Going back further, to 1998, we find that the reaction to this high negative TICK is very unusual. Only 22 times in these six years has the S&P declined as much as it did today the day after we saw a TICK reading of less than -1000. While logic would suggest that if we see a selling climax (i.e. a high negative TICK) and the market keeps declining, then that is a very bad omen indeed. As most of you know, however, logic is rarely applicable when it comes to the stock market.

Out of the 22 days that exhibited such a pattern, the S&P 500 was higher 10 days later 20 times, a win rate of 91%. The average return was 4.6%, which extrapolates out to an average annual return of around 116%. The maximum loss suffered was 3.8% while the maximum gain was over 15%. That maximum gain was recorded two years ago, as the TICK hit -1067 on October 8^th then continued to decline on October 9^th. That close on the 9^th of course proved to be the low. If fact, looking at the last few times this pattern emerged, the future prospects look bright indeed:

This pattern last emerged after 9/11, in late July 2002, mid-October 2002 and mid-May 2004, each of which is marked on the chart. While the S&P was higher only about 50% of the time the day after the occurrences, it was an average of more than 6% higher after 10 days and nearly 10% higher after 30 days, with each instance being positive.

I don’t want to stretch this comparison too far, because overall the sentiment picture is vastly different now than it was at the lows in 2001 and 2002, but the rarity of this pattern does present intriguing possibilities of a market that has already seen the bulk of its selling pressure. On a side note, many of you will have different figures for the TICK readings. Each quote vendor is different, and it shouldn’t matter which one you use so long as you remain consistent when doing historical comparisons.

Bottom Line: Despite some calls that a reversal in the VIX from very low levels is a negative omen, the actual data suggests that may not be the case.

Something that I’ve heard recently is that the jump in the CBOE Implied Volatility measure, or VIX, over the past few days is bearish because it reflects a change in sentiment – going from a regime of low volatility to one of higher volatility, which is normally a bearish development.

That is pretty much the understanding that I have too, but I decided to test it to make sure. What I looked at was any time during the history of the VIX that it jumped more than 20% over a 10-day period while it was still “low” by being under 20. To see if the opposite was true, that it would be a bullish signal to see the VIX decline from a high level, I also looked at those times the VIX dropped at least 20% while being “high” by being above 35. The table below shows where the S&P was 20 days later.

S&P 500 Performance After VIX Reversals 1986 - 2004
	When the VIX rallies more than 20% when under 20…	When the VIX drops more than 20% when over 35…
Average Return	2.1%	-2.0%
% of Time Positive	77%	43%
Maximum Return	9.4%	7.1%
Minimum Return	-4.1%	-12.7%

From the table, we can see that when the VIX reversed from a low level, the S&P was higher after 20 days more than three quarters of the time, with a respectable average return of over 2%. The maximum gain was more than twice the maximum loss, another good sign. On the other hand, when the VIX reversed from very high levels, the S&P was higher only 43% of the time, showed a negative average return, and the maximum loser was well above the maximum gainer.

There are innumerable ways to determine what a reversal is, or what constitutes “low” and “high”. But by using the basic parameters above, we can see that our current situation, of the VIX rallying more than 20% over the past two weeks while being below 20, has not historically been an accurate sell signal. In actuality, it has been a pretty decent buy signal.

Bottom Line: Even though it is option expiration week, it is still notable that the most common put/call ratio has closed in very high territory nearly every day for the past week. That has a definite bullish precedent.

I’ve touched on put/call ratios several times over the past couple of weeks, mostly from a longer-term standpoint. From the data available to us, it is evident that the very high ratios we have seen for an extended period of time is not due to some aberration from a fund selling puts to open or other activity, it appears to be a genuine attempt by traders to protect themselves from declining market prices.

The unusually pessimistic activity has continued in spades this week. Over the past five days, the total put/call ratio from the CBOE has closed above 1.0 every day but once. Going back to 1995, there have only been five distinct occurrences of the ratio being above 1.0 for four out of five days. The table below gives each of the dates when the ratio first hit 4 out of 5 days, along with the return in the S&P 500 the given number of days later.

Put/Call Ratio Above 1.0 For 4 Out of 5 Days 1995 - 2004
Date	5-day P/C Ratio	5 Days Later	10 Days Later	20 Days Later	30 Days Later
9/20/01	1.09	4.2%	9.5%	10.0%	11.4%
9/19/02	1.15	1.3%	-2.6%	5.5%	6.7%
5/22/03	0.94	2.9%	5.6%	7.0%	7.7%
3/16/04	1.05	-1.9%	1.3%	1.2%	0.4%
5/11/04	1.11	-0.4%	1.2%	3.0%	3.7%
Average Return		1.2%	3.0%	5.3%	6.0%
% Positive		60%	80%	100%	100%

Something that I have pointed out on several occasions in the past is that high put/call ratios do not usually coincide with the exact low of a market decline. Often, the high ratios are in relatively close proximity to the low in terms of price but not necessarily time. Meaning, the market often continues to chop lower after the high ratios, though it doesn’t lose very much and forms a low within a couple of weeks. As we see from the table above, every time we have seen such high ratios nearly every day for a week over the past 9 years, the S&P was higher each time within 20 days with a very respectable average return.

In the past few comments, I have been suggesting that it may be best to look to fade whatever short-term extremes we may see. We saw that in action after the gap up on Wednesday, and I suspect it will continue. As of today’s close, we have several factors in play that suggest we are now approaching the opposite extremes. Ideally, what we will see is another few days of moderate downside that builds the pessimism already evident. Odd-lot traders sold more shares yesterday than any time since July, and combined with the data points above I am seeing compelling reasons to suspect prices may not have a whole lot more to go on the downside.

Whenever we see “odd” market behavior, the possibility increases that there is some publicly unknown force about to be unleashed (think the LTCM crisis). The way the market has acted after the large negative TICKS yesterday is one of those “odd” things, so that has me a bit on guard, but if we look objectively at the history of the pattern, it certainly does not appear to support a bearish thesis. I do think that additional short-term weakness will be relatively quickly regained, and will now be looking more aggressively for long-side setups.

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.