A Couple of Things to Worry About

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November 3, 2007

2:00 PM EST

A Couple of Things to Worry About, But No "Bubble" Here

One of the complaints I get from time to time is that I call some investors "dumb". We track a compilation of indicators that we call Dumb Money Confidence, and some people take offense to that.

I think it's kind of ridiculous to get offended over someone calling an anonymous group of ever-changing market participants "dumb", but it still makes me go back from time to time and re-evaluate whether certain sets of traders are indeed good contrary indicators.

For the most part, I rarely find that their classification should be changed. People who trade certain instruments tend to become overly emotional at extremes, and as long as they display consistent behavior, it is those types of people who we want to monitor on a regular basis.

One of Those Groups - Small Options Traders

I've written about the positioning of the smallest of options traders twice over the past few months (in late July and again in early October), after these traders had become overly optimistic about further market gains. After both instances, equities got whacked shortly thereafter.

This group trades 10 or less options contracts at a time, with transactions that average somewhere between $200 and $2000 per trade.

Despite the recent volatility, these traders are at it again. For the latest week, small traders spent 47% of their volume buying speculative call options, and only 17% buying protective puts.

I put together a more comprehensive indicator this week, which takes into account their call and put selling activity as well. Basically, we're just going to look at their total bullish volume (call buying plus put selling), and subtract their bearish volume (put buying and call selling).

That gives us a kind of oscillator that swings back and forth as these guys and gals adjust their strategies based on the latest market movements. It is depicted below.

We can see that there is a general upward slope in the blue indicator line. This means that these traders have become more and more accustomed to rising prices, and have increased their bullishness on each successive push higher in stocks. They have also become less and less bearish on market declines.

This is a great example of the "institutionalized" mentality of a prolonged trend - as it progresses, with fewer and fewer meaningful interruptions, traders begin to project the past onto the future with increasing aggression. Traders have learned that dips are temporary and they shouldn't panic when they happen.

If we would zoom out the chart above, we'd see that these traders have now reached a point that was last seen in April 2000. Unfortunately, the data only goes back that far, so we don't have a whole lot of history to work with, but what we do have seems ominous.

Volume Also Showing Some Speculative Juice

The options market isn't the only one showing that traders may be becoming over-enamored with the bull market.

Over the past few weeks, volume on the Nasdaq exchange has swamped that of the NYSE. Watching the relative volume between those two exchanges has been a popular sentiment guide for decades, and it has mostly retained its effectiveness.

The theory suggests that as investors become risk-averse, they tend to hide in the most liquid, easily tradeable securities possible. For the most part, those have been listed on the NYSE. At the same time, they would hesitate to put money into higher-beta issues, which are often traded on the Nasdaq. So when NYSE volume was high relative to Nasdaq volume, then we could say that we were seeing a sign of risk-aversion.

We saw that to an extreme degree in September 1998, at various points from July 2002 through March 2003, and again in October 2005. Each of those occurrences marked excellent times to go contrary to that prevailing sentiment as equities took off on sustained advances afterwards.

But that knife cuts both ways. When we see Nasdaq volume exploding higher relative to NYSE volume, then the assumption is that investors have fallen in love with risk...and that usually doesn't end so well.

The chart below shows a month-long moving average of the Nasdaq/NYSE Volume Ratio that we post to the site. The red arrows highlight the couple of other times the ratio has moved to the kind of extreme we're seeing now.

That first instance in 1996 doesn't look so bad on the chart when we see what happened later that decade. But still, the performance in the indices going forward wasn't exactly stellar. Three months after the June 1996 spike in Nasdaq volume, the S&P 500 showed a return of -3.4%, while the Nasdaq 100 returned -4.3%.

The February 2000 occurrence was close to the market peak, though after three months the S&P still managed to stagger higher by +3.6%. The air quickly came out of the NDX, however, as that index was -26% lower after three months.

Conclusion: Some Troubling Signs, But We're Not at "Bubble" Proportions

The examples above that showed investors taking on an attitude of excessive speculation are relatively isolated. A quick look down our Complete List of indicators will show you that there are just a smattering of extremes...not everything has one of those dreaded red dots all the way to the right-hand side next to the bear.

Over the past few weeks, there have been other indicators that popped into an optimistic extreme, such as some of the different sentiment surveys and the Rydex and ProShares asset data. For the most part, though, the bulk of the measures we follow are somewhere in neutral territory.

While the indicators we went over above are suggesting we're in "bubble" territory, the vast majority of the others we follow are not. We don't have the same kind of explosion in margin debt (relative to cash levels) that we did in 1999/2000, or the spiking interest in pink sheet stocks, or excessive long positions by small speculators in the index futures, or a lack of short interest or corporate insiders betting against their shares.

So I'm not making the case that the bull market is doomed because small options traders are too bullish, and investors have once again found the Nasdaq an exciting place to be. Rather, the most likely course from here seems to be more of a choppy market where fading short- to intermediate-term extremes would do better than buying and holding either long or short. That's the approach I'm taking, and will be looking for some of those shorter-term extreme moves to take the other side.

All the best,

Jason Goepfert

President and CEO

Sundial Capital Research, Inc.

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