Short-term Outlook:  Neutral  From Jan 27, 1090 SPX

Equity Indicators - Updates and Extremes

Small Trader Put Volume

Heading into mid-January, we kept harping on the idea that the smallest of options traders (and pretty much everyone else, for that matter) were completely disregarding the allure of protecting their portfolios with put options, while at the same time they were piling into speculative call options.

That was one of the major reasons to expect downside follow-through after even a small crack in prices, as the precedents were clear that such activity normally leads to a struggling market.  Now that we've seen one of the worst corrections since then, have they changed their behavior?

Well, somewhat.  The chart below shows the percentage of total small-trader option volume that was spent on protective puts.  The green vertical lines coincide with notable lows over the past three years, along with the percentage of volume that went into puts at the time.

We can see that the most current reading, at 20%, is the lowest of any of them.  It's had to recover from a much lower level, of course, which is what was so troubling in December and January.

These traders are gradually warming up to the idea that having some protection probably isn't a bad idea, but it's still nowhere near the levels that we've seen preceding prior sustained bounces.

Reversal Bar

Back in March of last year, we took at a look at when markets tend to bottom according to the calendar.

I've read a lot of commentary this weekend suggesting that "The market never bottoms in February", and "Friday reversals are just sucker bets!"  In the interests of saving you a click, here's the chart we looked at:

It would be a little bit unusual to see an intermediate-term low on a Friday (which accounts for just under 15% of all bottoms) and February (about 8%), but neither one is outside the realm of probability.

Let's look a little closer, then, at Friday's reversal bar.  What we're going to look for are any times the S&P dropped to at least a two-month low (as it did Thursday), then the next day it declined at least as far as its 3-month Average True Range, before closing above the prior day's close (but below the prior day's high - we want to exclude the extremely powerful reversals that Friday obviously was not).  Let's also stipulate that total volume was the highest in at least the past week.

The table below shows all occurrences since 1962:

The biggest focus for me is the second column which shows the number of days until the S&P closed at a new two-month low.  The median number of days was only six, and there were only three occurrences in there (10/10/84, 10/28/97 and 08/16/07) that I would consider to be major bottoms.

That means that the vast majority of the time, these reversals did not coincide with the ultimate low, but rather the market had more work to do on the downside before a sustained rebound.

While we did see some modest short-term follow-through nearly three-quarters of the time, on occurrences we hit a new low within a week.  Since Friday's reversal was so meager, it wouldn't be difficult to do this time around either - we'd just need to close below 1063.11, and given the table above that seems pretty likely at some point.

On Friday, we look at a table that suggested some additional short-term downside should substantially raise the probability of a multi-week bounce.  We were close to see that, but the late afternoon rally actually was not what bulls should want to see, at least not yet.  As the table above shows, these reversals were often premature.