Options Data, Fed Chairman Conspiring Against The Market

02/10/09 9:20 AM EST

Good Tuesday morning...We begin the day with some selling pressure in the pre-market futures.  The indices are off their lows of the morning, but sold off a bit subsequent to the release of Treasury Secretary Geithner's speech due to be delivered later this morning.

On the blog on Friday we discussed the likelihood of stocks following through to the upside after the Payroll Report, but then running into trouble in the ensuing session(s).  There were several reasons for that, including the stats we went over in regards to big moves based on economic releases, consecutive up days during a bear market, and considerable overbought readings from our short-term aggregates.

A significant part of those overbought readings comes from the options market.  Over the past couple of weeks, despite a meandering market, traders have focused heavily on trading call options as opposed to put options.

While we don't necessarily know who is doing what with those options (the ROBO Put/Call Ratio is more of a help with that), the fact that indicators like the Total Put/Call Ratio are stretching well outside of their bearish (for the market) trading bands is not a good sign if looking for a sustained rally attempt.

The chart below shows the 10-day moving average of that ratio, with the red dots highlighting other times during this bear market that the ratio reached the current level of extreme.

What's even more disturbing is that not only are the moving averages of this indicator well outside of their bearish trading bands, the raw daily number is as well.  It's understandable to get an extreme reading after a day like Friday - it's less so to see an even greater extreme on a day of chop like Monday.

Since 1995, there have been 42 days when then 10-day average has been stretched outside of its upper trading band, and then the daily reading stretched outside of its upper-most band as well.  Over the next week, the S&P 500 showed a positive return only 33% of the time, averaging -0.8%, and with an average maximum risk (-2.3%) more than twice as great as the average maximum reward (+1.1%).  That compares to a random week that had a 55% chance of being positive with an average of +0.1% during the study period.

There were only two days during a bear market environment when traders were brazen enough to push the put/call ratio to this level of extreme on both a single-day and 10-day basis, which were 08/22/02 and 03/20/03.  The former marked the exact top of the post-July bear-market rally and the S&P subsequently lost nearly -20% over the next 30 days.  The latter led to a short-term peak the following day, and the S&P lost about 4% over the next week or so before embarking on its great first run of the new bull market.

As for the ROBO Put/Call Ratio that I mentioned earlier, I'm afraid it's not telling us a whole lot at the moment.  It's been showing a relatively decent amount of pessimism among the smallest of options traders since July, with only one really good panic reading (the week of November 21st).  Other than that one week, we've mostly just seen apathetic trading with no actionable extremes either way.

While Mr. Geithner's plan to rescue us from ourselves will be the big focus today, there is also the matter of Mr. Bernanke speaking before Congress in the Semiannual Monetary Policy Report to the Congress.

We've discussed this event several times over the years, but it's worth touching on again, as we have seen some pretty consistent market action surrounding these speeches.

The day before the Fed Chair's testimony to Congress, the S&P 500 has been up nearly 70% of the time.  But the day of the prepared remarks, it was up 44% of the time, and the day after it was up only 28% of the time (7 out of 25 occurrences).

For some reason, these meetings have an uncanny tendency to occur very near market inflection points, with the market moving substantially in the other direction from the move preceding the testimony.  The chart below highlights these meetings (the gray vertical lines) superimposed on a chart of the S&P 500.

If the S&P 500 was negative over the month prior to the testimony, then the month following the meeting it was up 8 out of 10 times with an average return of a respectable +2.3%, though the risk/reward over the next month was about evenly distributed (-3.8% to +3.9%).

However, if the S&P was positive heading into the meeting, then the following month also showed a positive return only 13% of the time (2 out of 15 instances) and an average return of -2.8%.  The risk/reward was extremely skewed to the downside (-5.9% to +1.6%).  The last 12 occurrences, dating back to 1998, were all negative.

Despite the rally over the past week, the S&P is showing a negative one-month return heading into the Fed's testimony, so I suppose we could consider that a modest positive.  But we have rallied on a shorter-term basis heading into it, and while the edge isn't as strong as the one-month returns, they are still negative following the meeting.  Historically at least, it would have been much better had we been dropping into this meeting instead of rallying.

Bottom line - Intermediate-term

We went over several studies in December (here and here and here) indicating that what we witnessed during November marked a major bottom.  But after what we went through to begin the New Year (e.g. the spike in Dumb Money Confidence and Intermediate-term Indicator Score, the failed breakout at 920 on the S&P, the subsequent losses of support at 880 and 850, and the failure to bounce off short-term oversold conditions), that probability diminished substantially.

Because of that January failure, I had been leery of buying into weakness until we either saw more of a pessimistic extreme in the Dumb Money, or an improved technical picture.  The Dumb Money recently dropped under 40%, but that's still nowhere near the previous pessimistic extremes under 20% that we saw at prior bottoms.  As for the technical picture, it is what I would consider lukewarm - not too hot, not too cold - as we remain trapped between 800 and 925.

With not much of an intermediate-term bias among our indicators, and an inconclusive technical picture, I see little edge in pressing any positions with a one- to three-month time frame.

Bottom line - Short-term

On the subscriber blog on Monday, we discussed some tendencies related to Friday's reaction to the Payroll report and the consecutive up days we'd witnessed heading into the beginning of the week.

The tone of those studies was negative, and that is furthered by the put/call data we looked at earlier.  I'm also not particularly enthused that the market has been rallying into the Fed Chairman's testimony today, or that we had such a narrow-range day yesterday.

For the past couple of days, I've been thinking that we would run into some resistance near 875 on the S&P, and we stopped precisely there yesterday.  Given that and the relatively negative studies we've discussed, I still think we're going to have difficult sustaining any upward pressure for the time being.  I would become even more confident of that outlook should we gap open below yesterday's low and set a lower intraday low after the first hour of trading today.  Should we see that, I intend to trade solely from the short side unless we would happen to reverse above yesterday's high.

All the best,