A Smart Money Gauge Is Bullish, But It May Not Matter

02/12/09 8:55 AM EST

Good Thursday morning...We begin the day with some selling pressure in the pre-market futures as overseas weakness helped to squash any optimism from yesterday.  A better-than-expected Retail Sales figure helped to save the S&P from violating 820 a bit ago, and that will be a big focus today.

In the "bottom line" intermediate-term summary towards the end of these comments, I've been repeating the idea that we saw some major positives for the market in November and into December - an incredible amount of historic oversold types of readings at the bottom, then several signs of a buying thrust that really only occur at intermediate-term lows.

But then we hit mid-January.  We saw signs of excessive optimism via the Dumb Money Confidence, then a false breakout in the S&P that ended up slicing right back down through important support levels.  That makes it hard to have a lot of confidence in those readings from November/December.

There are still several reasons to be longer-term positive.  Economic sentiment surveys are dragging along at multi-decade or all-time lows, there is enough cash sitting in money market funds (not to mention brokerage firms, bank CDs, ect.) to outright buy a large portion of the components of the S&P 500, and individual investors were recently holding more cash than stock, historically a major buy signal.

Another indicator flashing bullish potential is the "smart money" OEX Put/Call Ratio.  These are options trades based on the S&P 100 index of largest companies within the S&P 500.  Typically, when we see heavy call option volume relative to put volume, stocks rally going forward and vice-versa.

At the top in October 2007, this ratio was quite bearish for the market, and appropriately so it turns out.  But it has been sliding steadily since then (meaning more call volume than put volume), and that has picked up steam lately.

Over the past couple of weeks, the data has indicated that these traders are turning over only 67 puts for every 100 calls, an exceptionally low number.  It's so exceptionally low, in fact, that we haven't seen a comparable reading in more than 20 years.  Late October 1987, in the wake of Black Monday, is that last time the ratio dipped to this kind of extreme.

The chart below shows a composite of the moving averages we post daily to the site.  It is simply an average of the 5-, 10- and 21-day moving averages of the OEX Put/Call Ratio.  This gives us a good feel for just how extreme the ratio is on a short- and intermediate-term basis.

The red line is a long-term subjective trend that highlights how the ratio has moved in tune with the market - becoming very bearish near the top in 2000, very bullish near the bottom in 2002, and very bearish again in 2007.

Remarkably, 18 of the past 21 days has seen more call volume than put volume, the largest concentration of such readings since late July 2002.

This has usually been a good sign.  Over the past 20 years, if the composite of the averages shown above was less than 0.90, then the future one-month return in the OEX averaged +2.0% with 67% of the days positive.  If it was over 1.50, however, then the one-month average was only -0.3% with just less than 50% of the days positive.

That sounds good...but does it matter?  Consider the chart below.

As recently as 2006, the one-month average of daily total OEX volume was around 70,000 contracts.  It didn't often drop below 60,000 contracts, and sometimes shot upward of 100,000.

Most recently, though, volume has been hovering around 30,000 contracts or less, the lowest in at least 7 years.  More worrisome is the red line in that chart - as a percentage of total option volume, OEX contracts have gone from about 6% of the total to 1% or less.

Extremes in the OEX p/c ratio have continued to do a pretty good job at highlighting extremes in the market as well, and in a non-contrary fashion.  I see no reason to change the indicator's status as a decent "smart money" guide.  But I'm very concerned about the increasingly pathetic volume, because low volume makes it much easier to generate spurious and misleading extremes.

There's also the problem of the Total Put/Call Ratio that we looked at on Tuesday.  That's giving us a fairly strong sell signal.  Looking over the history of the two ratios, the only times I can find where the total p/c ratio and the OEX p/c ratio were giving opposite signals in close proximity were February 2000 and January 2006.  In general, the signal from either ratio was more consistently successful if the other was at the opposite extreme.

The fact that these traders have been so focused on call options is still a good sign for the market, of that I'm convinced.  But I am not convinced that it is enough of a reason to ignore the more-reliable Total Put/Call Ratio, which is giving us the exact opposite signal.  If we see OEX traders continue to focus on calls while overall put volume picks up, then we will be able to make a better case for a sustained rally.

Bottom line - Intermediate-term

We went over several studies in December (here and here and here) indicating that what we witnessed during November marked a major bottom.  But after what we went through to begin the New Year (e.g. the spike in Dumb Money Confidence and Intermediate-term Indicator Score, the failed breakout at 920 on the S&P, the subsequent losses of support at 880 and 850, and the failure to bounce off short-term oversold conditions), that probability diminished substantially.

Because of that January failure, I had been leery of buying into weakness until we either saw more of a pessimistic extreme in the Dumb Money, or an improved technical picture.  The Dumb Money recently dropped under 40%, but that's still nowhere near the previous pessimistic extremes under 20% that we saw at prior bottoms.  As for the technical picture, it is what I would consider lukewarm - not too hot, not too cold - as we remain trapped between 800 and 925.

With not much of an intermediate-term bias among our indicators, and an inconclusive technical picture, I see little edge in pressing any positions with a one- to three-month time frame.

Bottom line - Short-term

On the subscriber blog on Monday and the morning comment on Tuesday, we discussed the multiple short-term negatives that had accumulated.  We reached an overbought condition, with a narrow-range day, following a big move on an economic report, with excessive call activity.  After we hit a new intraday low below Monday's low, the probability of a further decline was very high.

Tuesday's decline erased some of those negatives, and our most sensitive indicators actually reached a minor oversold reading by that day's close, but the limp rebound yesterday was enough to push them back into neutral.

At the moment we continue to cling to the uptrend line from the November low through the lows hit in January and earlier this month on the S&P 500.  According to that theory, 820 on the index should be support.  Most are watching the January closing low around 800, which also rejected several downside attempts.  So there is some potential support stacked from 800 - 820 on the S&P and the potential longer-term positives we've discussed still have a shot at playing out as long as that support can hold.

With our guides mostly back to neutral and the indices still mired within a clear trading range, I don't see much of an edge in either the short- or intermediate-term.  I would give a modest bias to the long side as long as remain above 800ish.

All the best,