Small Ranges + Bullish Bets = Danger

Sunday , January 2nd, 2005 11:00am EST

In the 1990’s, I had a first-hand look at the raw emotion that many investors exhibit with their investments. As the manager of operations for what became a relatively large discount brokerage, one of my responsibilities was overseeing the margin department. By watching the flow of applications for margin and options accounts (particularly from those with no previous experience), I could see when the prospects of quick riches were overtaking careful analysis.

That experience came back to haunt me this past week, as I checked with some of my contacts still in the brokerage business. Applications for margin and option accounts are up several-fold from where they were a year and a half ago, and while they’re not seeing the wild-eyed excitement from years past, my contacts were busy with trying to fulfill these accounts.

I’m not one to place too much emphasis on anecdotal evidence — I feel a lot more comfortable if I can put some reliable numbers down and look at historical patterns. With the beginning of the new year, it’s an excellent time to visit several measures that we follow that are based on real money. These are not traders’ opinions, they are not surveys, they are not guesses. Every measure discussed below is generated by looking at what traders are actually doing with their hard-earned capital.

Generally, we group traders into two categories – the “dumb” money and the “smart” money. I don’t particularly like either moniker, but they are colorful descriptions that help us to remember that we should bet against the “dumb” and bet with the “smart”. So let’s take a look at a few measures that track each group. And remember, these indicators are based on what traders are actually doing with their money.

First, the Dumb Money

Bottom Line: They are long and getting longer.

Our first measure is the R.O.B.O. put/call ratio TM. This indicator looks only at the very smallest of options traders, which are those that trade 10 contracts or less at a time. We further restrict the indicator to look only at those transactions that are being bought to open. Unlike traditional put/call ratios you may see elsewhere, with this measure we get to see exactly who is doing exactly what. When these small traders (the average transaction size here is between $200 and $2000) trading these highly leveraged instruments feel strongly about a particular market direction, they have a consistent tendency to lose money.

For the latest week, the ROBO put/call ratio closed at 0.33. We can flip that ratio around and discover that these smallest of traders are buying three times as many calls as they are puts.

This type of unbridled enthusiasm from this type of trader has only been exceeded once since the bubble days of 2000, and that was near the top last January. When small traders feel so little need to protect themselves (or speculate) on a move lower in the market, that’s when I prefer to look for one.

Now, let’s look at the traders who frequent the Rydex mutual fund family . I know a lot of very sharp investors who use these funds, so it’s difficult to describe them as “dumb”. But, whenever a bunch of people are leaning the same way, we start to see some group-think develop, and when there are too many rushing to one side of the boat it has a tendency to capsize.

My preference with this fund family is to look at the total dollar amount of assets in the leveraged funds only. These funds move $2 for every $1 the underlying indexes move, and from my experience as the manager of a margin department, I know for a fact that people behave differently when they are leveraged.

In the chart below, the green line represents the total dollar value of leveraged assets in the S&P 500 and Nasdaq 100 bull funds (that rise when the market rises ) and the red line is the total assets in the leveraged bear funds (that rise when the market falls ).

Since September 23 rd. the S&P 500 has gained 9%. Impressed by the rally, traders have poured so much money into the leveraged bull funds that the assets have risen by 64%. While some of that is new money, and some more of it came from the money market, most of it appeared to come from the leveraged bear funds, which have seen their assets cut in half during this time.

These traders are not betting to a large degree on a move down in the market, and they are not hiding in the money market (whose assets as a percentage of the total are now lower than at any time since 2001). They are betting heavily on a further rally, and it looks like this boat is becoming awfully crowded.

The last dumb-money indicator we will look at today is our Odd Lot Purchase Percentage . An odd lot trade is one that is executed for fewer than 100 shares, and is generally considered to be a reflection of small-trader sentiment. The indicator simply looks at the number of shares these traders buy on a given day as a percentage of total odd lot volume. The higher the indicator, the more these small traders are buying.

Over the past two months, these traders have concentrated about 55% of their orders on the buy side. This is one of the highest percentages in recent history – exceeded only by late 2000/early 2001 when they were buying hand-over-fist in anticipation of a resumption of the good times that had just ended. Another time that approached the current one in terms of the amount these traders were buying was June 1992, after which the S&P struggled in a trading range for four more months.

Now, the Smart Money

Bottom Line: Not very optimistic, and becoming even less so.

Something I have touched on a few times over the past few weeks is the total nominal dollar value of the outstanding positions of large commercial traders in the full and e-mini contracts of the S&P 500, Nasdaq 100 and DJIA. There has been a tremendous surge in short positions from these traders, which as of the latest release totaled an eye-opening $35 billion.

This type of huge bet on the short side of these futures contracts is equaled by only one other time in history, which was the week ended March 6 th. 2001. After that instance, the S&P went for a sickening plunge of 172 points before bottoming later that month (during which, of course, the commercials were busy buying back those short positions!).

Our current situation is different in several respects, most notably the fact that much of the commercial short position now is in e-mini contracts as opposed to the full contract. Still, it is a reflection of real money moves from large traders and should be noted.

Next, let’s touch on the OEX put/call ratio . I know several traders of OEX options that I unfortunately would hesitate to call the “smart money”, but the behavior of traders in these options continues to be a good non-contrary guide.

This data gave an “infalliable” buy signal in August ( click here to read the comment which discusses it), but now they are quickly running to the opposite end of the field. The chart below is a 21-day average of the put/call ratio in OEX options.

We can see that the ratio has risen dramatically over the past few days, to the point that it is now higher than any point in the past few years other than January 2002 and June 2003. The open interest in these options is also heavily skewed to the put side, and over the past couple of weeks these traders have shown a large degree of determination to have exposure to a market decline.

Lastly, let’s take a look at the Smart Money Indicator . This measure was popularized by the incomparable Don Hays, who has used it regularly to confirm his other signals.

The way I have calculated it in the chart below is to subtract the performance of the S&P 500 cash index during the first Ѕ hour of trading and to add the performance of the S&P during the last Ѕ hour. The idea behind this is that more emotional trading takes place at the beginning of the trading day (as traders react to overnight news event and economic releases) while the smart money takes the day to evaluate price action and input their orders before the market closes. Therefore, we want to bet against the opening action and bet with the closing action. I’m not quite convinced that the idea behind the indicator is completely valid, but it’s hard to argue against that fact that looking at the trading day this way has added value in the past.

We can see that at the bottom in 2003, the S&P was opening very poorly and closing very well. All the news at that time was bad indeed, and we would often see the market dip in the opening hour or so of trading after traders digested the bad news before the market opened. However, by the close it would often make a comeback, which could be considered accumulation by the smart money.

Recently, we have seen the exact opposite, as the following chart of the past two days’ action in the S&P shows:

Whether we can put much weight on this indicator is unknown, and it certainly can become more extreme and continue for an indefinite period of time. But this real-money reflection of market action has bearish connotations and again is something we should note.

Conclusion

In recent intraday comments. I noted the S&P and Nasdaq’s tendency to have a good day on the 2 nd trading day of a new year, with both indexes being up 74% of the time with very good average returns. On that day, the S&P has been positive 40 times out of 54 years – not a lock by any means, but consistent enough to expect some sort of strength to begin the year.

One question mark for this year, though, is inflows to equity mutual funds, which have been far below what we saw in 2004. There have even been a few weeks of outflows lately.

Total assets at fund firms are approachin g all-time highs (see chart to the right), while the percentage of their assets held in liquid instruments like cash is scraping along near all-time lows. If cash levels are low, and investors begin to redeem an increasing number of shares at these funds, then how can the managers meet the redemptions? By selling. It is a vicious cycle, because that selling will push prices down which will cause more redemptions which will cause more selling.

I also mentioned in the intraday updates that the volume for the SPY exchange-traded fund had fallen behind the volume of the underlying component stocks for 13 consecutive days, one of the longest streaks in years. We look at this information as the basis for our Liquidity Premium, which shows how much of a premium investors are giving to the liquidity and ease of trading of the exchange-traded funds SPY and QQQQ. When the Premium is low, then investors are preferring to trade individual equities as opposed to ETFs. That is a sign of confidence, and recently that confidence has been what I would consider excessive.

Over the past few weeks, I have been harping on the fact that the market simply does not show large declines during the last 10 trading days of December. I have also shown that the indexes, particularly the Nasdaq 100, very often show a swift, steep decline during the month of January. We have one more day of what has traditionally been a strong time of year, but after that the market has to deal with its issues…no more seasonality to bail it out. That is why we are modestly short in the model portfolio, and looking to increase that position if we see a day or two of gains to kick off the new year.

I want to wish each and every one of you and very safe, happy and prosperous 2005! As always, I want to make this service easier to use and more useful for you. We have received some great ideas from subscribers which I believe have benefited everyone. So please, if you have any feedback as to how the site can better meet your needs, I’d love to hear it.

Jason Goepfert

President and CEO

Sundial Capital Research, Inc.

Disclosure: no positions

This disclosure is not intended as trading advice in any form. It is meant as a note to subscribers that the author may have a position directly affected by the market outlook reflected in the commentary. Although the author takes great pains to remain objective in any commentaries, it is only fair that readers should know that the author may have taken positions in accordance with his market outlook. Positions can and do change at any time, without notice to the reader.