Draggin' Breadth

Looking at the price changes in the major indices it might appear that Monday was a quiet day with little out of the ordinary. In fact, the higher closes in the S&P 500 and Dow masked some substantial selling that took place. Breadth was strongly negative on the NYSE, both in terms of advancers vs. decliners and in terms of up volume vs. down volume.

In fact up volume was nearly doubled by down volume. It made up less that 35% of the total of the two. I looked back to 1970 to see other times when up volume was less than 35% of up plus down volume while the S&P 500 closed positive on the day. I was fairly surprised to find only 4 other cases. They were 3/27/80, 1/25/82, 10/4/94, and 3/23/05.

To see what poor breadth on an up day may suggest I then loosened the requirements some. In this case I changed the requirement from 35% up volume to 45% or lower up volume. Below is a summary of the results.

It appears that the weakness in the broad market tends to act as a drag on the S&P over the subsequent two weeks. Whatever was holding the S&P 500 up in the face of the instance-day weakness eventually ends up falling as well.

On another note, the CBI moved up to “6” today. Any higher and we’ll be at levels where I normally being scaling into long index positions.

Market Scared - But Perhaps It Should Be

Tonight I’m just going to share a few quick observations that may put the current situation into perspective:

1) Brian C., sent me a study he did on VIX spikes hitting extreme levels. On Friday the VXO closed over 20% above its 10ma. I looked at this in a study and compared my results to his. They both said pretty much the same thing. More often than not the VXO spike leads to an S&P bounce fairly quickly. Those times that it doesn’t - watch out.
2) I looked back in history to find all the times when the S&P 500 gained at least 2% in one day and then lost all of its gains and more the next day - similar to this Thursday and Friday. No need for an elaborate display of the results here. It only happened once - March 24, 2003. In other words, 2% rises are simply not supposed to get wiped away in one day. There is no reliable precedent for what happens next.
3) The CBI didn’t budge and remains at “3”. This indicator remains neutral. In a market that is selling off in an unprecedented way I’d be more comfortable taking a shot on the long side if this was spiking. Perhaps with a few more days of selling, but right now I’m not seeing anything that is screaming buy.

Why You Need To Normalize The Put/Call Ratio

No time for research tonight. I spent the night at the Garden. Yeah Celts.

In lieu of a study, I instead prepared a chart of the CBOE Total Put/Call Ratio. One thing traders need to keep in mind when looking at certain indicators is that they may change over time. The put/call ratio is a prime example of that. The chart below is weekly. The green dots are the Friday closing prices of the put/call ratio and the brown line is a 40-week moving average.

Often times I hear traders refer to absolute levels in put/call ratios as if they are significant. What you can see by looking at the chart above is that “significant” has change over time. From ’97 to ’02 a “spike” in the ratio over 1.00 could have been viewed as significant. A trader seeing such a reading may conclude that fear among option traders was running high. Now a reading of 1.00 is below average. A reading of 0.5 would sure be significant, though. In 2000 it was about average. Strategies that may have been developed 7 or 8 years ago that looked for a move to a certain number are now likely obsolete. That doesn’t mean the put/call ratio has stopped working as an indicator, though.

The issue lies in the fact that the popularity and use of options for traders and institutions has changed over time. It will continue to change. To adjust for this you should normalize the readings over a certain time period and then compare the current readings to “normal”. There are a number of ways to do this. Comparing to a moving average using percentages is a simple and effective one. Another way to normalize the put/call ratios would be to use Bollinger Bands (try varying lengths). The specific method is not terribly important. The fact that it is done is important if you don’t want your strategy or study to become obsolete.

Nasdaq Stays Strong

Bank rumors and speeches from Bernanke turned a positive start to the day into an afternoon selloff. The Dow and S&P 500 lost all of their gains but the Nasdaq went virtually unscathed, with the Nasdaq 100 finishing over 1% higher. I looked back at all the times the S&P closed lower while the Nasdaq 100 closed at least 1% higher. Below are some summary statistics:

Additionally, about 86% of these instances closed higher than the trigger day close sometime in the next week.

You may also notice that some sentiment gauges like the put/call ratio and the VIX have spiked a bit in the last few days. Traders seem to be getting a bit jumpy. Compare this week’s selloff to the one two weeks ago and you’ll see the indicators spiking just as sharply or more so even though this selloff is more benign. That is generally a good thing.

Most everything I’ve been looking at since Monday says we are likely to bounce. There seem to be a few wildcards to keep in mind, though. The banks are one. They need to halt their freefall. Friday’s unemployment report is another. Markets tend to react to that report more severely than most.

When Months Start Bad

After shooting higher to begin the month the previous few months, the market decided to throw a curveball in June. These first two days have been a fairly rough start. I decided to see how SPY has historically reacted when the month got off to a bad start. For purposes of the test I shall define “bad start” as a down close the first 2 days and a loss of at least 1.5% over those two days.
Going back to 1993 I found 14 occurrences. Here are their stats over the next week:

Also notable is the fact that all 14 closed higher than the trigger day at some point over the next week.

Tough to put too much stock in a seasonal-type study like this one. (They are my least favorite from a trading perspective.) Still, combined with some other positives I’m seeing, such as last night’s breadth study and last week’s volume study, I’m inclined to believe we may see some upside sometime in the next few days.

This Setup's Been Favorable Since The Last Time They Met In The Finals

The market sold off fairly hard on Monday with decliners swamping advancers by more than 2 to 1. Volume was light, though.

I ran a test to see how the S&P has reacted following a day when it was down at least 1% on 2:1 or higher declining breadth. What was most interesting about this test is that results were significantly different in the last 21 years than they were before that. From 1960 up until the Crash of ’87 the results were as follows:


From the Crash of ’87 until today they look like this.

Buying and holding for a week after such a day would have been a winning strategy every year since 1987 except in 2006. Prior to that – consistent loser. In case you're wondering, using lower volume as a filter improved results slightly.

I’m not sure why the change. Perhaps the Crash changed the psyche of the market. Traders may have decided if it could bounced back from that, it could bounce back from anything – and so dip buying became fashionable and profitable.

Whatever the reason, since 1987 days like Monday have fairly consistently provided an upside edge over the next couple of weeks.

And speaking of 1987…they’re baaaaack!

Put/Call Drop

After spiking a little the week before last, the CBOE Put/Call Ratio dropped fairly sharply over Wed-Fri. Below is a study I ran last night showing the implications of similar drops:

Not the most bearish study I've ever seen, but it hints that the market may struggle to add to its gains over the next 2-4 days. I'm seeing some warning signs that the going could be tough here very near-term. Caution may be warranted.

Friday also posted an "inside day". If you'd like to review possibe implications of this, you may want to check out the old inside days studies.