In the Sweet Spot, But...
Wednesday, December 22nd, 2004 11:53pm EST
Cash is Being Put to Work
Bottom Line: Available Cash at NYSE clearing firms is disappearing, but that has actually been a good longer-term sign in the past.
Yesterday on CNBC, my friend and excellent market strategist Tony Dwyer of FTN Midwest Research showed the chart of NYSE Available Cash that we post to the site. I last discussed this indicator on May 24th, and the conclusion at that time was that there was plenty of firepower left in the brokerage accounts of customers, but we needed them to show a willingness to buy by seeing an increase in margin debt.
Very briefly, the Available Cash figure is obtained by taking the total margin debt in customer accounts at NYSE-overseen brokerage firms and comparing it to the amount of cash sitting in margin and cash accounts at those same firms. Since cash is an asset and margin debt is a liability, by subtracting the debt from the assets, we can get a snapshot of a kind of “net worth” of these total customer balances each month. Since 2001, this Available Cash figure has been mostly positive, meaning there has been more cash in the accounts than there has been margin debt, which is an extremely unusual development – the last time we saw such a thing was in 1951 – and it is in stark contrast to the bubble days, when there was nearly $2 in margin debt for every $1 in cash in these accounts.
The latest margin figures just released from the NYSE, which covers data through November, shows that the Available Cash figure went negative for the first time in 9 months. Margin debt rose by 6.1% (one of the largest month-over-month increases in four years, and the biggest jump since May 2003) while customer cash balances rose by only 2.2%. While this seems negative on the surface, as I wrote in May we need to see customers more willing to spend the money in their accounts to have some faith that all this cash on the sidelines is actually being put to work. If we did see margin balances increase, it should result in higher equities prices.
If you have a margin account, then you most likely know that your brokerage firm doesn’t care how you use the money you borrow from them (assuming you leave enough equity in your account to cover the margin requirements!). So an increase in margin debt doesn’t necessarily mean that customers are buying stocks hand over fist with the money they borrow. Instead of leveraging their accounts to buy more stocks, they could just as easily be withdrawing the money to buy a car, or upgrading their home or going on a vacation. Most brokerage firms tag the accounts with margin interest rates that are above the Prime Rate, and the rates are generally higher than home equity lines of credit, but well below most credit cards, so it’s hard to say exactly what this margin debt is being used to buy. But I think it’s safe to say that most people use it to buy more stock, and is one reason why an increase in margin debt is usually associated with an increase in equities prices.
Over the past three months, the Available Cash figure has been trending lower, as the following chart shows.
Again, this is not necessarily a bad thing. In fact, looking over the past 50+ years, any time the 3-month average of this indicator has been trending lower, the S&P 500 was higher three months later an impressive 72% of the time, with an average return of 3.5%. However, when Available Cash was trending higher, then the S&P was positive three months later “only” 54% of the time and its average return was barely positive. Six months and nine months later, the average return in the S&P when the indicator was falling was triple those times when the indicator was rising, so that supports the view that it is positive to see this cash being put to work as opposed to just piling up in customer accounts.
There are few sentiment indicators I can point to that support a case for higher equities prices, but this is one of them. It is one of the longest-term indicators we follow, and most certainly does not preclude the market from suffering shorter-term corrections, but it is undeniably bullish for those with an outlook of several months or more. There is a large amount of buying power available for customers at NYSE and NASD clearing firms, and should those customers continue to have an increasing appetite for risk by borrowing against their holdings, it should directly benefit the broader stock market.
The Siren Call of the Vixen
Bottom Line: Implied volatility of Nasdaq 100 options is about in line with its historical volatility, and past Decembers show a similar drop to what we’re seeing this year.
Implied volatility on index options has been low for months on end, and yesterday they took another large dip, with the Nasdaq 100 volatility index (VXN), dropping significantly despite the fact that the underlying index did not jump to a new high. That type of non-confirmation can be a bearish sign, but I would prefer that it be more pronounced, and over a longer time period, before assuming that it is going to result in imminently lower prices.
Implied volatility has a tendency to decline during these holiday periods for a variety of technical reasons, and that has certainly been the case for the VXN over the past few years. The chart below shows how the VXN has performed from the 5th trading day in December through the 3rd trading day in January over the prior three years.
There is a clear downward bias every year, as the volatility measure has lost an average of about 12% during this time of year. So far this year, it has declined over 15%, so we’re ahead to schedule in that respect. This larger-than-average decline, coupled with the fact that the NDX has not made a new high, is a minor bearish development, and something that adds to the idea that we are seeing an excessive amount of complacency. However, the NDX during those three years was seemingly not affect by these drops in volatility until the new year was introduced. The index didn’t top out until an average of 8 trading days had passed in the new year, which is in perfect concert with a study I showed last year.
That study noted that since 1986, the Nasdaq 100 had shown a decline of at least 5% in a 10-day window in January in 15 out of 18 years. The average top was formed by the 8th trading day of the month, and the average decline was just over 9%. The index followed that pattern pretty closely this year as well, as it dipped about 5.4% (from high to low) in 7 trading days beginning with the 12th trading day of the month. This is a consistent pattern, and should the market hold up into the new year, I suspect we will see a similar situation play out in 2005.
Conclusion
There have been 9 times since 1950 in the S&P 500 where the index made a new yearly high in the last 10 days of December. The average return from that day through the third trading day in the following January was 1.4% with 6 of the 9 being positive. The largest loss was 2.2% while there were three instances of gains greater than 2%, so again when the indexes perform well this late in the year, they have a tendency to continue into the new one.
The string of consecutive days of the ISE Sentiment Index closing above 200 has been snapped at 15, as the Index finished Wednesday with a reading of 176. Three full weeks of traders buying to open more than twice as many calls as puts has set new benchmarks for levels of optimism in that Index and it suggests that whatever rally traders enjoy in the coming days will ultimately be erased. My conclusions have not changed from what I have been mentioning in the intraday updates – we are in the “sweet spot” for buyers, as sellers typically just step away from the market. We often see spikes in the indexes (like Tuesday) where there is very little selling pressure, but I believe that whatever gains we see during this time, provided our measures continue to show the levels of optimism we’re seeing now, will be given back by February of next year.
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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