Some Missing Pieces, But Still "Extreme"

10/20/08 9:10 AM EST

Good Monday morning...We begin the new week with some buying interest in the pre-market futures, with the major indices currently up about 2% from Friday's close.  Trading continues to be highly volatile, with a 40-point swing in the S&P 500 between Sunday's overnight low and this morning's high.

This week's economic calendar is exceptionally light, so traders will be focusing on continued developments in the credit market (which is still barely moving) and a flurry of earnings reports.  According to Bloomberg, there are 139 companies in the S&P 500 reporting their results this week.  So far 79 have reported, with an average +2.6% surprise above analyst forecasts.  57 have been a positive surprise, 22 negative.

During the last leg of this decline, one of the broad categories of sentiment indicators that didn't reach the kind of extreme it should have given the magnitude of the selling pressure was put/call ratios.

There are many variations of those ratios, with most of them focused on the relation between the volume of put options that are traded versus the volume of call options.  Generally, put options are used to bet against stocks, while calls are bets on a rising market, so a high put/call ratio signals excessive pessimism.

That's a very broad generalization, but it usually holds true - when stocks drop, we see put/call ratios rise and vice-versa.  After dragging their feet, we have seen most of the well-known put/call ratios rise lately, with the 10-day average of the Equity Put/Call Ratio now beyond its bullish (for the market) trading band and on a par with where it was at past market lows.

Part of the reason we may not have seen the expected extremes is due to the temporary ban on short sales, which caused all kinds of havoc with various indicators.  So looking at the headline numbers, it's hard to get a feel for who is doing what in the options markets.

That's why I like the R.O.B.O. Put/Call Ratio and its components.  Here we are only looking at the very smallest of options traders, and only their opening transactions.  With no trade larger than 10 contracts, it's unlikely that the traders are buying puts for any reason other than protecting their portfolios or betting on a market decline.  And they are buying call for pretty much only one reason - speculating on a rally.  So it's about as "pure" a look at the options market as we're going to get, with few distortions from the games played by other, larger traders.

The chart below shows two aspects of small trader options trading over the past eight years.  We're looking at the percentage of total volume made up by buying call options (speculation on a rally) and the percentage made up by buying put options (bets on a market decline).  The latter in shown on an inverse scale, so the lower the two indicators are on the chart, the more the smallest of traders are betting against the market.

Unfortunately from a contrary perspective, we're still not seeing these guys and gals get all that pessimistic about the market.  Last week, they spent 32% of their total volume on buying speculative call options, down just a tad from the prior "worst week in history" in the indices.  And their put purchases only increased from 22% to 24% of total volume, well below the nearly 30% we saw near the end of the last bear market.

I've pointed out this lack of fear among small traders several times over the past couple of months, and it still bugs me.  It's just one indicator floating in the large sea that we follow, and it's not really enough to change my outlook.  But it is enough to make me slightly less aggressive in looking for a major low than I otherwise would be - if these folks were spending 30% of their volume on put purchases, and only 20% or so on calls, then I would be even more optimistic about our prospects over the coming weeks.

While there are certainly missing pieces to the puzzle, most of our guides have reached one level of extreme or another.  If you look at the "Indicators At Extremes" graph on the Daily Overview page, you'll see that last Monday about 70% of all of our indicators were residing in bullish (for the market) territory.

That was close to a new record high, telling us not just that some indicators had become very extreme (which can push our other models into extreme territory), but that many indicators had become at least stretched enough to be considered notable.  It's kind of a breadth measurement of our indicators.

That graph just shows the last five days, so it's tough to put current readings into an historical context.  For that reason, starting immediately we're updating a new chart on the site which shows these percentages dating back to the year 2000.

As you can see, the chart shows us the percentage of our indicators currently residing at a bullish (for the market) extreme, the percentage at a bearish extreme and the net difference between the two. 

Last week, the percentage at a bullish extreme approached a new record, closely matching the 70% level hit on July 23, 2002 and March 10, 2008 - both times to be looking for at least an intermediate-term rebound.

As we discussed last week, we already know that we've seen a lot of extremes over the past couple of weeks.  Maybe the most ever.  We've witnessed a level of volatility rarely seen, in fact perhaps only one other time (1929) in the past century.  The major equity indices are about as stretched from their 52-week highs and 200-day moving averages as they've ever been in their history.

When we consider the huge magnitude of sentiment-, breadth- and price-based extremes we've seen, it's hard to argue that we're not in store for an intermediate-term recovery.  Even during the worst markets in history, when the markets have become this stretched the selling pressure has abated for awhile.

A week and a half ago, we went over the reasons why I thought October 10th should result in a selling climax.  Since that point, the market has pretty much played out the usual post-crash scenario, though the pullback last week was significantly deeper than I thought was likely.  Still, I haven't seen anything which makes me want to change my outlook for decent gains during the fourth quarter, and I remain most interested in buying into short-term dips, preferably those that trigger short-term oversold conditions and with the indices holding above some notion of technical support.  It'll take a move below the lows on October 10th to change that.

Last week, our shortest-term guides hit overbought levels twice, and stocks fell apart within hours both times.  That's not what we usually see during healthy, recovering markets that are emerging from severely oversold intermediate-term conditions.  Usually indices like the S&P 500 hold up or rally right through overbought conditions like that, and it's one sign of buying demand we have yet to see.

The drop on Friday afternoon wasn't enough in terms of price or time to bring most of those short-term guides out of their overbought condition, so we're still seeing a test here.  If the market can hold up under these conditions - and a gap up opening on a post-option expiration Monday - then we'll finally have some decent confirmation of buying demand and it may finally be time to start to become more aggressive with long trades.