Snapshot Notes - May 19, 2008


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MONDAY, MAY 19, 2008

Demand For Protection Becoming Scarce

05/19/08 9:20 AM EST

As of:

SPX 1375

HELP ARCHIVE

Good Monday morning...We begin the day with no real movement in the pre-market futures, as the weekend news flow was slow. The economic calendar isn't all that busy either, though the Leading Indicators today and PPI tomorrow could have some impact with a surprise either way.

One of the indicators we follow that has been showing signs of excessive optimism is the put/call complex. Watching how much traders are buying call options as opposed to put options, we see that there has been a marked increase in call option trading over the past couple of weeks, with the 5-, 10- and 21-day moving averages now poking above their bearish trading bands.

We also watch this data on a de-trended basis, meaning that we compare current readings to how they've moved over the recent past. That allows us to more accurately compare current readings to historical ones, without the distorting factor of the big trends that put/call ratios tend to display.

As you can see from the chart on the site, the De-Trended Equity Put/Call Ratio is now at -15%. The last few times it reached this level were July 2007, July 2005, November 2004 and January 2004. Those dates might not have lined up with exact highs in stocks, but the upward bias did flatten out (at best) after those points.

Let's take a look at the smallest of options traders (trading 10 contracts or less at a time) to see if they're doing anything different. One of the ways I look at the data is viewing how much of their total volume is made up of speculative call buying and protective put buying. When we get an extreme in either, it's been a pretty good contrary signal over the years.

The chart below shows how much of their weekly volume is being consumed by buying protective put options. When we see a spike in the ratio, then it means that they're scrambling for protection, and should be bullish for the market. When the ratio reaches a low level, then it shows a certain amount of complacency, which is when the market often runs into trouble.

One issue with this data is that it has shown a gradual uptrend since 2000, and has formed a clear channel over the past few years, which is what is shown below. When the ratio reached the upper channel, a little green arrow shows up on the S&P 500 chart; when it dropped to the lower end of the channel, a red arrow appears.

We can clearly see that returns were better after the green arrows than the red arrows, which is no surprise. What worries me about our current juncture is that the ratio has been hovering around the lower end of the channel, which hasn't coincided with the best times to be long stocks lately. We may have seen some additional gains over the next few weeks or so, but every time those gains were given back in quick, sharp contractions.

While we may be in the beginning stages of a new, extended bull market (some of the studies we went over in March suggested just such a thing), I remain in "prove it to me" mode. We're still in a long-term downtrend, and are sporting an increasing number of disturbing readings, which we've spent the better part of the past few days and weeks discussing.

I distinctly remember having this same kind of attitude in April and May 2003 - we were overbought on a large number of sentiment measures, and were still in what I would consider a long-term downtrend. That was the wrong outlook to have, since we morphed into a bull market during those months. But one thing was very evident at the time - prices continued to creep higher without much in the way of corrections during those months, and when prices do that, we have to pay attention instead of being stubborn.

So we could be in the midst of the next great bull run, but before moving over to that camp, I will have to see something similar to the price action back in 2003 - if we keep moving higher and prices don't correct when they "should", then that will be sending a loud and clear signal to me that I've been wrong in assuming we're still mired in a downtrend and I will be adjusting again to full-on bull-market mode.

For the short-term, we have a number of different negatives that we went over during the past few days, and we should be seeing those kicking in here. If they don't, then I will have no choice but to remove myself from the short side and wait for a better setup from either side. I have had a definite preference for shorts, which has not been a good strategy lately, and just as a matter of risk control I will not be able to tolerate being on the wrong side much longer. The only way I'd continue or re-enter is if we see signs of failure among the indices, such as them trading back below their recent breakout areas (1420ish on the S&P, 2000 on the Nasdaq 100 and 740 on the Russell 2000).

All the best,

Jason Goepfert

President and CEO

Sundial Capital Research, Inc.

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