Letting The Volatility Play Out

10/21/08 9:15 AM EST

Good Tuesday morning...We begin the morning with selling pressure in the pre-market futures, as an initial rally in overseas markets wasn't enough to generate any enthusiasm in our domestic futures, and some not-so-great earnings reports have not helped the cause.  With the credit markets gearing up a bit, the focus will turn more and more to company fundamentals and the economic outlook.

So far this earnings season, 61 firms in the S&P 500 have shown positive earnings growth compared to 43 with negative growth, not a great ratio.  A total of 69 have beaten expectations, compared to 33 that have fallen short, but we're not seeing those with positive surprises reacting all that well just yet.

Yesterday we looked at a breadth-like measure of our indicators, the Indicators At Extremes, which showed that we'd recently seen not only a few indicators becoming very extreme, but a lot of indicators becoming at least somewhat extreme.

That's not surprising, since we've spent a lot of time over the past couple of weeks looking at the various and multiple extremes among the sentiment-, breadth- and price-based indicators that we watch.

There are a few exceptions to the rule, indicators that should have been more stretched than they were.  Put/call ratios were among them, and while some versions of the ratio did hit extreme levels, and while we may have to discount these readings somewhat because of odd behavior related to the ban on short sales, it would be a little more comforting if we were seeing objective evidence of too much pessimism.

The example we looked at yesterday was the option buying behavior of the very smallest of options traders last week.  Far from being totally scared out of the market, these folks have been clinging to only very modestly concerned levels, not the kind of panic we've witnessed in other indicators.  That's not enough to totally derail the likelihood of an intermediate-term rebound in the market, but it would be better to see these traders betting heavily against a rally.

Last week's option expiration impacts the put/call ratios as well, and I tend to not read too much into the options data in the days immediately surrounding expirations.  Still, yesterday's closing figures were quite low, with the Equity-Only Put/Call Ratio dropping to 0.62, its lowest level in almost a month.

That was enough to push the ratio outside of its bearish (for the market) trading band that we show on the site.  The ratio has pushed outside of that band 33 times over the past year, and during the next three trading sessions the S&P 500 has managed to show a positive return less than one third of the time, averaging -0.7%.  Multiple-day rallies that generate some optimism have not been treated kindly during this bear market.

That's something we've been keeping an eye on over the past week.  Our most sensitive indicators have pushed into overbought territory twice since last Monday.  The first time, stocks gapped up the following morning then basically crashed.  They cycled into overbought again by Friday afternoon, and the S&P slid about 40 points immediately thereafter.  But we saw a gap up opening yesterday, on a Monday following an option expiration no less, and we not only saw stocks hold up, but rally strongly.

That's a good sign of latent buying demand, something that has been sorely lacking over the past year, and the past couple of months especially.  Volume declined for the second day in a row, but I'm no fan of trying to use market-wide volume in the sense of "accumulation" and "distribution" days - that concept simply doesn't work.  Just take a look at past intermediate-term lows, and you'll see that volume tends to spike at the exhaustion point, then drop as stocks recover.  There is nothing inherently bullish or bearish about it.

For the short-term, I see no edge here.  We're modestly overbought, and there is that possible sense of optimism in the put/call ratios, both of which are a knock against more of a rally at the moment.  With the indices already dropping 2% at the open, neither one is a lot of help at the moment.  I continue to like the probability of an intermediate-term rally during the fourth quarter, and want to use trips into short-term oversold territory to trade from the long side.  As we rally, I have less interest in chasing prices, and I don't see that changing either, so for the moment I'm doing nothing and will let this volatility play out until something better sets up.