November Is A Little Top-Heavy

Posted At 8:45 AM EST

Good morning...We begin the day with some buying interest in the pre-market futures.  The economic calendar is pretty light this week, but the largest slug of earnings reports will be released this week and next, so we will be subject to a constant roller-coaster ride as they hit the tape.

Last week was options expiration, which often leads to some of the more extreme options indicator readings we see.  That doesn't necessarily mean that they're less effective, just that those extremes tend to occur around expiration.

Last week was no different, as we witnessed a string of extremely low put/call readings.  That would suggest that traders were optimistic, but we don't know for sure whether they were buying or selling options, and whether the transactions were to open or close positions.

That's why we follow the weekly indicators such as the ROBO and LOBO Put/Call Ratios, and Options Speculation Index.  The ROBO Ratio follows the opening options transactions of the smallest of traders, the LOBO Ratio tracks the largest traders, and the Options Speculation Index follows everybody.

From those measures, we can see that the smallest traders apparently became even more optimistic last week, sporting their most skewed preference toward calls yet since the recovery began in March.  Historically, however, the market has run into more trouble when the ROBO Ratio reaches 0.40 or so, and it's not quite there yet.

The LOBO Ratio that watches the largest traders, though, is at a true extreme.  Last week these guys and gals spent 36% of their total volume buying call options to open, which is the largest allocation in five years.  The only other week since 2000 that exceeded last week's number occurred at the end of January 2004 (right before the market went into a multi-month correction).

Probably most concerning out of all the data is the Options Speculation Index.  That indicator looks at the ratio of all bullish activity (buying calls and selling puts) to all bearish activity (selling calls and buying puts).  The higher the ratio, the more speculative the activity.  Last week's reading was the highest in four years, and other weeks when it has been about this high, the market typically went into a multi-week or multi-month trading range at best.

That leaves open the question of whether it's likely we form any kind of a top here or not.  After all, the market has (so far) passed with flying colors the tests posed by the seasonally weak September and the seasonally volatile October.

If the sellers aren't eager enough to halt the market during this time of year, then surely the market won't top in November or December, right?  I mean, those are two of the strongest months of the whole year, and as we discussed on Friday, the rally so far this year doesn't necessarily suggest anything different this time around.

And if we make it though September and October, then how likely is it that we top in November or December anyway?

Well, let's take a look on four different time frames.  The charts below show the percentage of time since 1928 that the S&P 500 has formed 1-month, 3-month, 6-month and 12-month highs during each month of the year, and the subsequent average decline after those peaks.  By "1-month high" for example, what we're looking at are those days where the S&P did not exceed that price for 1 month prior to and subsequent to that date.

From the chart, we can see that the average month should account for about 8% of all of the 1-month highs (the red horizontal dashed line).  January, July, August and November were a bit above average, while October and December were well below.

That's interesting - while the market didn't often make shorter-term peaks in October, it did more often the next month, November.  And while December was below-average, January was well above.

Now let's look at the average decline from those peaks.

Somewhat surprisingly, November peaks showed the largest average decline over the next month, followed by January.  So how do we resolve that with the knowledge that December is usually a pretty strong (and consistently positive) month?  Well, we're still talking about low probabilities of the market topping, but when it does top in November then the subsequent decline has been a bit worse than average.

Now let's look at 3-month highs:

Here the distribution changes quite a bit.  The summer months of July and August account for the largest share, and July really sticks out.  The rest mostly hang around average, except for June and December which are grossly under-represented.

Even though July accounts for a lot of the 3-month highs, the average drop is actually below average.  When the market has peaked in March and September, the subsequent three months have shown the worst returns out of any of the other periods.

Let's zoom out again and look at 6-month peaks:

The distribution hasn't changed too much, with July making up an even larger percentage of the total, while May, June and December bring up the rear.

September's peaks still show a larger-than-average decline when they occur, but we now also see that from May and December.  Those last two have to be taken with a grain of salt, however, because each only represent one occurrence.

Now for the last distribution, 12-month highs:

Compared to the previous charts, we can see a shift to August and November (April didn't have any).  These are the big-picture peaks, when it takes at least a year for the market to recover from the subsequent damage.

It does seem odd that November is so well-represented, however we have to account for the fact that there were only 22 peaks that qualified for the study, and November made up 3 of them (14% of the total).  So we're still talking about low-probability events here.

The average decline following all 12-month highs was -22.5%, and most of the months didn't stray too far from the average, though declines following February, June and August peaks were all under -20%.  The worst were March and September peaks (again, May and December only had one).

So what's the overall takeaway?  Probably the fact that while November and December have been positive months, it's actually not all that uncommon for the market to form short- to intermediate-term peaks in November - in fact, November is above-average across every time frame we studied.  In other words, we can't rest on our laurels if we see signs of a top heading into November...just because it happens to be November.

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Intermediate-term Signal Strength:    Neutral since Apr 9th (843 SPX)

(click here for archive)

Beginning in early March, we discussed a large number of reasons to expect an imminent rally of one to three months' duration.  Some of those studies were even more positive, and suggested a new bull market.

During mid-April, the market held up extremely well in spite of being overbought.  This is very rare during an ongoing bear market, and added to the idea that "this time is different" in terms of bear market rallies, as we reiterated in early May.

On July 10th, we looked at a number of short-term oversold readings, and like a good market does, it responded by rallying strongly.  The rally since then has been remarkably persistent, rolling over a multitude of indicators and studies that argued for a pullback.  As we discuss ad nauseam, a market that does not respond to short-term extremes usually has more work to do in the direction of the extreme.

We've seen some periodic bouts of excessive optimism during that time, and the market has pulled back in the very short-term after them.  But each time, the major indexes have held technical support, and rallied from even intraday oversold readings, so we've seen little change in the uptrend's character just yet.

We've been watching how the markets recover from the Key Reversal Day from a couple of weeks ago.  Right in line with its precedents, it has recovered well, and so we continue to see very little evidence of major topping action.  We don't have too many sentiment measures arguing that we're seeing long-term signs of excessive optimism, and the technical action of the market has been superb.  Until either one of those changes, there isn't much reason to expect a major change from what we've seen over the past six months.

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Short-term Signal Strength:  Neutral since Oct 5th (1029 SPX)

(click here for archive)

We finally saw some weakness on Friday that helped to fulfill some of the bearish tendencies that had cropped up earlier in the week.  But after the gap down and early-morning weakness, we once again saw a low form by 10am or so and a steady march higher into the afternoon.

That was enough to push most of our shortest-term guides back to neutral, but a few longer-term ones have now moved into bearish (for the market) territory.  So for the first time since mid-September, we now have 0% of indicators at a bullish extreme and 30% or more at a bearish extreme.  Every time we've seen this since the March low, the market has almost immediately entered a multi-day or multi-week period of choppy to lower prices.

Until we again see a pattern of lower highs and lower lows, I'm not all that interested in trying to sell short - the trend has just been too strong.  Maybe if we got up to 1120 or so in the S&P, I'd be more willing to take a shot just based on the numerous signs of probable resistance at that level, but until we either see an exceptional display of excessive optimism or some failures in the uptrend, shorting just isn't all that attractive.  As for buying, given the Indicators At Extremes, that doesn't seem all that appetizing either so I'm doing nothing trading-wise on a multi-day time frame.

All the best,