MONDAY, AUGUST 25, 2008
Laboring Ahead Of The Holiday
08/25/08 4:15 PM EST
This morning we discussed options traders, and how the last two days of put/call ratio readings weren't exactly encouraging. While the smallest of options traders had pulled back significantly on their speculative call buying, they also stepped back on buying puts to protect their portfolios, which is not something we've seen during past bottoming behavior.
Late last week, we went over a number of negatives, each of which was relatively trivial on their own, but when taken in combination didn't look all that appetizing. That confluence of negatives isn't as compelling as what we saw during April and May, but it was enough to make the prospects of the post-July rebound appear less and less appealing. Looking to buy every oversold blip and mostly ignoring overbought ones began to seem like a less than ideal strategy.
Today's drop was enough to erase all of the gains from late last week. Bulls may be able to take a little bit of solace that this is happening on a Monday, due to the market's tendency to reverse from early-week slammings. Since 1950, when the S&P 500 has lost this much or more on a Monday, it has shown a positive return over the next three days 66% of the time, averaging +1.1%. Since 1982, that has increased to a 72% win rate and +1.6% average - due partly to the major bull market during that time, and partly to the increasing tendency for the market to reverse after short-term extremes.
If we go back and again look since 1950, separating out the occurrences between bull and bear markets, we see that during bear markets this mid-week rebound setup succeeded 56% of the time for an average of +0.7%, but during bull markets 77% of the time with an average of +1.6%. That's a big difference, and considering we're currently in a bear market environment, not exactly encouraging.
One other wrinkle is the upcoming holiday. Taking a quick look to find what's happened in the past when the S&P dropped at least 1.75% four days before an exchange holiday, we see that buying that day's close and holding through the close the day before the holiday the S&P was positive 83% of the time (15 out of 18 occurrences) averaging +1.8% (the three losers were -0.2%, -0.4% and -1.3%). The average maximum loss over during those four sessions was -1.1%, less than half the average maximum gain of +2.6%, so there does seem to be a fairly solid positive edge to these pre-holiday sell-offs.
This morning I mentioned that given the small pile of negatives, I couldn't find much that was helpful for the bulls. A 2% haircut in a day will help to change that, and we're seeing some minor signs of that now. Several of our most sensitive indicators are in or close to oversold, and we have the potential positive post-selloff reaction mentioned above. Given that, if we see the S&P able to hold above last week's lows (1260ish), then it's not hard to imagine we'll get another upside try heading into the holiday. Below those lows, and I become even more defensive.
Negatives Begin To Mount
08/25/08 9:10 AM EST
Good Monday morning...We begin the new week with a pullback in the pre-market equity futures as Oil rebounds, foreign markets mostly retreat and we get yet more troubling news out of the financial sector.
Each week, I like to review the activity of the smallest of options traders from the prior week, as it allows us a much more definitive view on who is doing what than the daily data we get from places like the CBOE.
Last week, there was a fairly large change in these traders' behavior after a month of doing essentially the same thing. Their purchases of speculative call options dropped from 34% of total volume the prior week to only 30% of volume last week. During the depths of the last bear market, the figure declined all the way to 20%, so it's not like we're seeing an exceptional extreme, but over the past five years intermediate-term market lows have coincided with readings at or near this 30% level.
Unfortunately, there's a counter-point. At those prior market lows, we also saw a big spike in their buying of protective put options - they panicked and bought puts while they backed off on buying calls. Last week, though, they pulled back their buying of calls and puts, reducing their put buying to only 19% of total volume. At past market lows, that figure jumped to 25% or more.
So if they reduced their call buying and their put buying, then where did they concentrate their volume? Selling call options to open. That strategy made up 33% of their volume, up from 28% the prior week. This is really odd behavior, since in the past when we saw a spike in call selling (a neutral to modestly bearish strategy), it coincided with a jump in put buying, telling us that these traders were quite negative overall. But we're not seeing that this week, instead it looks like small options traders are just about as confused as everyone else and not prone to making big bets on any one outcome here.
The broader Equity-only Put/Call Ratio put out by the CBOE ended last week with back-to-back days with the ratio being more than 20% below its six-month average. As we discussed on Friday, that's not a positive for the market. Combined with a few other potential negatives we discussed then (a spike in positions in VIX futures, potential trouble for the US Dollar, broken uptrend lines in the S&P and DJIA, an inability to rally well from short-term oversold conditions, and a market that has already met its typical bear market rally objectives), it seems as though a strategy of continually buying into short-term oversold readings and mostly ignoring overbought ones doesn't make as much sense as it might have since the panic indications from mid-July.
In response, I've snugged up trailing sell stop orders on intermediate-term longs, and will be more willing to sell into overbought conditions going forward. It's arguable that we hit overbought with Friday's rally, and we're already seeing a negative reaction this morning. It's going to be tough to read much into this week's holiday-influenced week, as so many traders are on vacation and volume should slip to its lowest levels of the year. There is some consistent positive seasonality ahead, but it's pretty much only seen on the day immediately before the holiday, so other than that I don't see a whole lot that's helpful for the bulls at this point.
All the best,
President and CEO
Sundial Capital Research, Inc.
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