If Dollar Correlation Holds, Potential Trouble Is On Tap

08/22/08 5:00 PM EST

As of: SPX 1251 HELP  ARCHIVE

This morning we touched on the Equity-only Put/Call Ratio, and how it had moved more than 20% away from its average over the past six months.  That kind of extreme ostensibly means that options traders are overly enthusiastic, and it has been a relatively consistent contrary indicator.

The low put/call ratio from yesterday was unusual due to the weak performance of the equity indices, since the market typically shows a more acute move on days we get an extreme in the options ratios - like today.  And once again, we saw a large amount of calls traded relative to puts.

The last time we had back-to-back days with the put/call ratio more than 20% below its average was in mid-May, just as the market was topping out.  The time before that was mid-April, which just led to a short-term correction, and before that it was mid-July 2007, again a topping point for the market.

Since the early 1990's, back-to-back days of low ratios led to positive three-day returns in the S&P 500 just under 40% of the time with an average of -0.4%.  That's not horrendous, but it's significantly below random due to the roaring bull market during most of the study period.

Another wrinkle to consider is the latest Commitments of Traders report.  One of the newest contracts covered in the report is the one for VIX futures.  This contract measures traders’ expectations of future volatility, with the VIX usually having a very high negative correlation to the stock indices.

The latest data shows small speculators holding their second-largest net long position in the four-year history of the contract.  Small specs are usually a reliable contrary indicator, but that has not been the case with VIX futures – the last time small specs were this net long the contract was in early May 2008, just before the VIX ramped higher and stock indices declined.  The history of this contract is still too short to have a lot of confidence in what the positions are suggesting, but it doesn’t look like a positive for stocks.

Also a bit troubling is the positioning in the US Dollar.  As we went over last Friday, the correlation between the Dollar and the S&P 500 has been quite strong over the past month, and isn't showing any sign of slowing down.  The latest data shows speculators in the Dollar have moved to their second-largest net long position in history as of this past Tuesday (just shy of 30,000 contracts).

Large speculators are currently holding 71% of all outstanding long contracts, and small specs are holding 10%, leaving "smart money" commercial hedgers with just minimum exposure.  The only other instance with larger long exposure from specs was mid-November 2005...just as the Dollar was topping out.  Combined with the latest Public Opinion which showed the most bullishness towards the Dollar in two years, and the rush to get into the Rydex Strong Dollar fund, it seems reasonable to expect the currency to take a breather over the coming weeks - and if the correlation holds, then that would likely coincide with a break in stocks as well.

To reiterate what we discussed this morning, over the past couple of days we've gone over the idea that while the market has met the usual targets we look for during a bear market rally after the panic from July 15th (lasting one to three months with a gain of 5% - 15%), we hadn't really seen any indicators or studies suggesting the recovery was about to end, unlike what we saw in April and May.

But recently the S&P 500 and DJIA broke their uptrend lines from the July low, and the NDX had been unable to rally well from an extended period of oversold readings from its STEM.MR Model.  Now we have the (minor) negatives we went over today.

I've had an exclusive bias towards buying into short-term oversold conditions and not doing much during overbought ones, but I'm less convinced that's going to be a successful strategy from this point.  I don't think the risk/reward justifies being out-and-out bearish yet, but as a modest bull I'm becoming increasingly uncomfortable.

Have a safe and relaxing weekend (or week for many of you), and we'll see you next week!

Market's Prospects Are Looking Increasingly Dubious

08/22/08 9:10 AM EST

Good Friday morning...We begin the day with a large gap open indicated in the pre-market futures.  Assigning cause to broad market moves is often a fool's errand, but the pre-open movement in the futures is tracking very closely to the action in Lehman Brothers, the object of a potential acquisition by the Korea Development Bank.  With Financials rallying, the Dollar surging and Oil dropping, the recent inter-market correlations bode well for the S&P 500.

Checking the history of the Korea Development Bank, they have had a clear bias towards buying out-of-favor assets, almost all on friendly terms, and they have a good history of following through on their announced deals.  So far this one's just a rumor - they have to actually announce a takeover or capital infusion first - but based on that state-run bank's history, it looks like Lehman should actually get the capital.

On August 6th, we went over what's happened in the past when the Equity-only Put/Call Ratio moves as far outside of its trading band as it did the day prior (showing a lot of call option volume relative to put option volume, ostensibly a sign of speculation).  The short-term results were not positive, and indeed the S&P dropped 23 points the following day before recovering.

We saw another extreme in the ratio yesterday, with it moving about 20% away from its six-month average.  This is unusual given the small gains seen in the broader equity indices yesterday - typically we see significantly larger gains in stocks on days the put/call ratio drops to such a low level.

I checked the past 15 years to look for any other times the ratio moved 20% below its six-month average on a day the S&P gained +0.25% or less, then gapped up the following morning by +0.5% or more, as it's indicated to do today.  Buying the equivalent of today's open and holding 'til the close resulted in 55% winning trades (6 out of 11 instances) averaging +0.1%, but holding an extra day dropped the winning percentage down to 36% and the average return to -0.9%.

Three trading days later, only 3 of the instances were positive and the average return was -1.5%.  Two of the positive occurrences gave their gains back within the next two sessions, while the other positive took two weeks before ultimately giving back the gains.

We're also seeing a drying up of Odd Lot Short Sales, small-trader bets that stocks will fall, with the latest reading the lowest in a month and a half.  Some of that has to do with a fall-off in volume in general due to the vacation season, and we should also keep in mind that this indicator has an erratic and not entirely consistent history of being a contrary indicator.  However, over the past three years, when Odd Lot Shorts have dropped to this low of a level a week later the S&P 500 was positive only 23% of the time (3 out of 13 occurrences) and sported an average return of -0.6%.

Over the past couple of days, we've discussed the idea that while the market has met the usual targets we look for during a bear market rally after the panic from July 15th (lasting one to three months with a gain of 5% - 15%), we hadn't really seen any indicators or studies suggesting the recovery was about to end.  That was unlike April/May, when there were a plethora of warning signs.

But recently the S&P 500 and DJIA broke their (admittedly obvious) uptrend lines from the July low, and the NDX has been unable to rally from an extended period of oversold readings from its STEM.MR Model.  Combined with the data we went over above, I would not suggest that we have an open-and-shut case for weakness directly ahead - far from it - but it's enough to give me more doubt about this rally than I've had since mid-July.

I haven't been doing much trading-wise over the past couple of weeks, and given the chop we've seen maybe that's a good thing.  I've been carrying some intermediate-term long positions for the past month, and haven't done much with them, but due to what we've gone over today I'm going to hike up some trailing stop orders to get me out just below the low of the past couple of days.  That would unfortunately leave only minor gains on the trades, but I'm starting to become more leery of relying on the goodwill we generated in mid-July and don't want to get stuck trying to look for support in what I believe is a continuing bear market.  Since July, I've had an exclusive bias towards buying into short-term oversold conditions and not doing much during overbought ones, but I'm less convinced that's going to be a successful strategy going forward.  I'm not bearish yet, just a modest bull with an increasingly cocked eyebrow.