A Day Of Reckoning

02/24/09 8:55 AM EST

Good Tuesday morning...We begin the day with very modest gains in the pre-market futures.  They were up 1% or more in the early morning hours, but have given back much of those gains heading towards the open of regular trading hours.

On February 12th we looked at the "smart money" OEX Put/Call Ratio.  At the time the 5-, 10- and 21-day moving averages had reached an extremely low level, suggesting that those traders were concentrating as heavily on call options as any other time in the past 20 years, and historically that was a good sign for the market going forward.

One troubling thing about the data, however, was that overall OEX option volume has been shrinking as a percentage of total option volume, and that remains a concern - yesterday's OEX volume was only 0.9% of the total.

Once again, we're seeing a remarkable extreme in the data.  Only 9,900 OEX put options were traded yesterday, compared to 30,700 calls.  The resulting put/call ratio of 0.32 is the lowest in the past 25 years of history that I have.  That's pretty remarkable considering it includes low-volume holidays when it's much easier to see extremes than normal market days like yesterday.

There have been 7 days with an OEX p/c ratio less than 0.5, meaning twice as much call volume as put volume.  The S&P 500 was positive the following day 6 of the 7 times with an average of +0.9%, but after that we return more towards normal probabilities of an up market.

I'm not sure how much to read into this data because of the relatively low volume and the fact that the market has not responded in spite of a continued extreme in the OEX put/call moving averages.  But I still consider them market-positive and that's even more the case after yesterday's exceptional reading. 

On Friday we discussed the Up Issues Ratio, and how the gap down open was likely a short-term exhaustive event based on history.  We did get a reversal on Friday which obviously didn't stick, and Monday we got yet another day with less than 1/3 of the securities on the NYSE closing in positive territory.

That marks the first time since 1994 that we've seen a streak of five straight days with fewer than 1/3 of the securities on the NYSE rising on the day.  Since 1940, it has happened 24 times, and over the next couple of sessions the S&P 500 was positive 21 times, an 88% success rate.  The three losers were all exceptionally small (-0.2%, -0.6% and -0.5%).

Unfortunately, it was not necessarily a harbinger of anything other than a short-term snapback.  From the close 2 trading days later, the next 3 days were up only 35% of the time, meaning that very often we saw a quick rebound, then at least some re-testing of the low.  Only three of the instances were situations where the market just continued to take off of an intermediate-term low without much of a giveback of the quick short-term gains.

That kind of streak is going to dampen sentiment, and we've seen some of that take hold in the past few days.

It's fitting that on a day the indices closed at their lowest levels in a decade or more, we're seeing similar "not seen in a decade" kinds of readings from some of our indicators.  Perhaps the most striking one is the Rydex Ratio, which compares assets in the bullish S&P 500 fund at Rydex to combined assets in the bullish and bearish funds (formerly known as the Nova and Ursa funds, respectively).

With $45 million in the bullish fund and $372 million in the bearish fund, the resulting Rydex Ratio of 11% is the lowest since 1995.

The only other days since '95 that the ratio dropped under 15%, prior to the most current debacle, were on 02/11/03, 03/12/03, 10/10/08, 10/27/08 and 11/20/08.  All were meaningful lows, at least temporarily.

This week is filled with economic data and government announcements.  Among them, tonight is the State of The Union address by President Obama.  Unlike major scheduled speeches by the Federal Reserve Chairman, these Presidential reviews haven't had any consistent market tendencies before or after.

The day of the addresses, the S&P was positive 52% of the time; the day after, 57%.  Either it's a statistical anomaly (yes) or we've had better speakers since 1994 (definitely not) but since then the day after has been positive 73% of the time, including 6 of the last 7 years.  This non-bias continues for at least the next couple of weeks.

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 is getting there with a current reading of 25% - low enough to be considered historically extreme - but that still doesn't approach the previous pessimistic extremes under 17% that we saw at each of the prior temporary lows since 2007.  That doesn't mean we can't rally, it just means that it's more difficult to define the probability of doing so.

As for the technical picture, the S&P 500 broke under the 800 area that had been support, and it's now hanging by a thread at the November lows.  Given the AAII data mentioned last week and a few other potential positives, I can't outright dismiss the potential of a meaningful low forming at any point, but without an extreme in the Dumb Money and the murky technical picture, I can't find a decent risk/reward scenario for supporting a longer-term trade at this point and would expect any rally emanating from these levels to be turned back near probable resistance at 800 - 830.

Bottom line - Short-term

Last week, we saw two days with gap down openings in excess of -2%.  That is an extremely rare occurrence, and as we discussed in the comments and on the blog, the S&P 500 has an extremely consistent tendency to close downside gaps that large within a week's time.

In addition, we had three straight days with an Up Issues Ratio under 33%, then a gap down opening on Friday.  Again, every time we've seen that kind of behavior, the market rallied over the next several sessions.  Friday and Monday saw that ratio under 33% as well, which we discussed above.

There have been 9 times since the inception of the S&P 500 futures that they were down 5% or more during an option expiration week.  Buying the S&P on Monday's close and holding for three days led to 8 winners out of the 9 occurrences, averaging a return of +3.9% and a nearly 2-to-1 reward-to-risk ratio (+6.4% versus -3.8%).  The one loser's losses were all made up over the following three days.  We've now also experienced consecutive 1% down days in the futures on the day of/day after option expiration. Of the 8 times this has happened, the rest of the week was up 7 times, averaging +4.5%, with the one loser being a minimal -0.1%.

With so many important economic reports and government announcements, I've been expecting an exceptionally volatile week.  Like I noted yesterday, the short-term studies we've discussed over the past few days have me confident that while the intraday activity could get scary, overall the bias should be higher this week and I'm much more inclined to try the long side than the short side.

We're firmly in waterfall-decline mode at this point, which makes it exceptionally difficult to decide if/when to try a trade.  I would become more aggressive with a move under 740 in the S&P 500 that culminates in some kind of panic selling that then recovers back above that level.  That's the kind of reversal that should stick, at least for a few days.

On a side note, yesterday on the blog we looked at the Arms Index (aka TRIN).  For the first time since 1940, it was showing an "overbought" reading under 0.50 on a day the S&P 500 was losing more than 2% of its value.  Other times we've seen low TRINs on big down days has been fairly bullish going forward, but in answer to some questions the reason for the low TRIN was due to three stocks.  If C, WFC and BAC had been negative instead of positive yesterday, the TRIN would have flipped from 0.53 to 1.40.  I don't like to make excuses for indicators, but it's worth noting the reason for the exceptional reading.

All the best,