Oversold Frustrations
Thursday, December 9th, 2004 8:50pm EST
Volume Explosion
Bottom Line: Volume in the SMH tracking stock set a new all-time record today by a large margin. Looking at other similar behavior in the past, there was usually short-term gains which were given back within 60 days.
One of the more spectacular aspects of today’s intraday reversal was the absolutely enormous volume attributed to semiconductor shares. The lowered guidance from several stocks after the close yesterday lead to some severe morning weakness, much of which was made up by the close.
The volume in the semiconductor tracking stock, SMH, ended the day more than 20% above the previous all-time record volume day and more than 100% above the average volume level over the past 50 days. Combined with the impressive intraday reversal, it looks like today was a climactic event in those shares.
The only other time we’ve had a similar type of instance this year was on May 12th. On that day, SMH volume was 105% above the 50-day average, it rallied more than 3% from its intraday low to the close, and it still finished lower than the previous close.
As we can see from the chart above, the reversal didn’t lead to anything spectacular, as semi shares sank for the next few days before staging a rally over the next couple of weeks.
Trying to find other occurrences in the history of the index, I can only find seven total instances (including the one from this past May) where SMH closed down on the day, but up at least 2% from an intraday low, while carrying volume at least 100% above the average volume over the prior 50 days. There was no real consistency among the other days over the short-term – some went up, some went down. After 20 days, 5 of the 7 were positive with a respectable average return of 5.5%. However, after 60 days, 6 of the 7 were negative and the average return dropped to a miserable -12%. It doesn’t help that 4 of the patterns showed up in the year 2000. Something different about this time, though, is that this is the only time the pattern occurred while SMH closed above its 50-day moving average. If you accept the 50-day average as a definition of trend, then this is the only time the pattern occurred in an uptrend. That could be a big difference from the others, but unfortunately we have no precedents to go on.
While volume in the SMH tracking stock was extraordinary, volume in the underlying components of the index was nothing to sneeze at either. There was just over 391 million shares traded in the 20 components of SMH, which is about 70% above the 50-day average.
We can compare volume in the tracking stock to the volume in the underlying components to perhaps get an idea of whether traders are favoring SMH or favoring the individual stocks. This type of analysis is the crux of the Liquidity Premium that we post to the site for SPY and QQQQ, and has been pretty effective at many significant market turning points. Generally, when we see traders flock to an exchange-traded fund like SMH in lieu of individual stocks, it has been a sign of excess uncertainty on the part of traders, which is often a sign that a market low is not far behind.
The chart below shows a 10-day average of the Liquidity Premium for SMH. The green highlights show those times the Premium was very high, telling us that traders were concentrating on SMH instead of individual stocks. The red highlights spotlight those times the Premium was very low, which means that traders shunned the ETF and instead felt comfortable enough trading the individual semiconductor names.
While the relationship of this indicator to future market performance is not as clear or consistent as the same data for SPY or even QQQQ, it did seem to do a pretty good job at identifying some of the short-term extremes, particularly the tops late last year and early this year.
Currently, the Premium is coming off an exceptionally low level, as traders seemingly abandoned SMH during late November, which should have been a tip-off that we could expect some weakness. However, that has changed dramatically over the past four days, and today’s reading was the highest in a month and a half, bringing the Premium back to a neutral level. Still, we have not seen the type of consistent and persistent preference for SMH over individual equities over a number of days that would push the Premium to very high levels, something that would give us more confidence in suggesting that traders are too uncertain on the group.
Conclusion
In the last comment, I showed a chart of odd lot short sales. In keeping with their apparent dose of skepticism about this rally, on Tuesday these short sales came in at a whopping 1.75 million shares, the largest total since the breakdown in the S&P 500 on August 6th, and the 6th-highest amount since 1970.
In stark contrast to that data, we see that the ISE Sentiment Index, something I discussed on November 29th, has stayed above 200 for the past seven straight days. This means that traders have been buying calls as an opening position at twice the rate they have been buying puts – surely a sign of speculation on further upside. Over the past 10 days, this Index has averaged 218, the highest reading since the market was topping early this year. On the other hand, the only other time there was seven straight days of 200+ readings was almost exactly one year ago, December 10th, 2003. That did nothing to stop the extraordinary rally to top off the year. This year’s reading is more troublesome because not only has the streak gone on for seven days, but the amount of call buying has been quite a bit greater.
In the last comment I suggested that another couple of days of choppy or downside action should set up nicely for a long trade heading into the waning part of the year. Today started out well and if we had close where we started we’d be further along in being able to define a high-probability trade from the long side. As it stands, today’s reversal left any potential oversold conditions frustrated. Should we continue higher into new highs, I would not be inclined to attempt shorting such a thing. We have another few days where the consistent positive bias to this month does not yet show itself, so there is still some hope that we can back off and establish a decent low-risk position.
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.