Short-term Outlook (1-5 Days):  25% Bullish  From May 21, 1056 SPX

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Equity Indicators - Updates and Extremes

Small Options Traders

One of the biggest tip-offs to future weakness that we discussed multiple times in March/April was the behavior of the smallest of options traders.  At the time, they were excessively optimistic about a rally, and that was not good.

With the severe shocks in the market over the past couple of weeks, we should obviously expect them to be more respectful of a potential decline, concentrating less on buying speculative call options, and more on buying put protection.

With the Total Put/Call Ratio shooting up to near a 15-year record last week, and multiple days of extreme readings, it would make sense if we saw small traders showing at least a bit of fear.

The chart below shows small-trader put buying as a percentage of their total volume.

Well, there has definitely been a pick-up in their willingness to spend money on put protection.  This spring, they were spending less than 15% of their volume on puts, and now it's more than 20%.

That's not too far from some of the extremes we've seen during this bull market, but it's well below the historical extremes in 2008 when we saw these guys and gals concentrating nearly 30% of their volume on put buying.

Now let's look at speculative call buying and see if their appetite for risk has been dinged.

Again, there has been a big change in their behavior, but it's not very extreme - even quite a bit less extreme than their renewed interest in put buying.  They're still spending about 35% of their volume buying calls, which is about in the middle of the recent range.  It has dipped under 30% when they've become pessimistic.

Overall, the data is disappointing for the bulls.  It would have been much better to see evidence of give-up among these traders given the market's performance last week.

Rydex Leveraged Bull/Bear Ratio

Several times over the past six months, we've discussed how trading in the index funds at the Rydex mutual fund family has changed.

Unlike before (prior to June 2009), we started to see extremely erratic trading, with daily swings of hundreds of millions of dollars, and much more of a "fading" behavior.  They had turned into short-term contrarians instead of longer-term trend-followers.

But when their positions became extreme, they still proved to be good contrarian indicators themselves.

On April 27th, we took a look at the Bull Ratio in the index funds, which had surged above 3 and was a warning of likely weakness ahead.  Now that we've gotten it, let's check back to see if they've changed.

Apparently so.  The Bull/Bear ratio in the leveraged funds has dropped to under 0.6, which is the 2nd-lowest reading in the past year.  There have been a few times it neared this extreme, but didn't quite reach it - still, even the near-misses all coincided with a market that headed higher in the coming week(s).

Let's zoom out a bit and look at the past five years and see how the current reading stacks up:

We can clearly see how trading in these funds has become much more erratic compared to historical moves.  But still, the current extreme is on a par with some of the lowest we've seen either during the modern era or the pre-manic one.

That's a good sign for bulls, especially with some of the other Rydex indicators confirming the excessive pessimism, like the Beta Chase Index, RSI Spread and Percentage of Sectors Wtih Assets > 50-Day Average.

Price Reversal From A Multi-Month Low

We've discussed the topic of price reversals many times over the years, and typically haven't been very enthused about them.  They're just not very reliable.  Sure, there are a hundred different conditions we can look for, any can pretty much massage the data any way we want to come up with an "appropriate" conclusion.

It's a slippery slope, so I prefer to keep the conditions to as few and common-sense as possible.  So basically, we're just going to look for any time the S&P futures closed at at least a three-month low (like Thursday) then dropped at least -1% the next day but rallied to close at least +1% higher (like Friday).

Price behavior following such reversals were short-term bullish, longer-term inconclusive.

The sweet spot for returns was four trading days later.  Here are the results:

Out of 13 occurrences, 11 led to positive returns, 1 was breakeven and one was a modest loss of -0.4%.  The rest averaged a median gain of more than +2%, with a reward nearly three times average the risk.

The worst part of the trade tended to be the first day after the reversal, which was up only 46% of the time.  If you bought that down day and held for three days, you would have had 7 winners out of 7 trades, with an average return of +4.5%.

Only 2 of the instances (10/08/02 and 09/16/08) saw the S&P trade below the low of the reversal bar over the next few days.  In both cases, the market ended up rebounding strongly immediately afterward, but that initial violation of the reversal low was no doubt cause for concern at the time.  As it would be if it happens again.

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