A FASCINATING INTERPRETATION OF THE PUT/CALL RATIO: VOLUME 3
Misinterpretations of sentiment indicators are common in today's market. Traders have become accustomed to looking at raw data for these indicators, without any respect for historical reference. The put/call ratios can be extremely effective if smoothed out and viewed from a relative basis. You do that by using moving averages instead of raw data and zooming out. Today we take a look at the equity put/call ratio. Traders like to refer to this as a "dumb money" indicator. This comes from the idea that smaller, retail investors enjoy getting involved in equity options and professionals tend to gravitate towards index options. I am not sure that there is a "dumb money" class left in this market. When even the small pockets of retail investors have a general grasp of contrarian theory, the act of fading the next guy becomes an exercise in futility. It's like the story of a hedge fund manager that goes to an investment conference and the first question the presenter asks, "How many of you in this room are contrarians?" 80% of the attendees raise their hands. The chart below displays the 20 day and 100 day moving average of the equity put/call ratio only. The bottom graph displays the S&P 500. I have marked important, multi-month tops with the vertical blue lines. You can see that there seem to be some definite requirements of where the 100 day moving average needs to go before important tops in the market are observed. This becomes all the more pronounced following periods of excess pessimism that are marked by important tops in the 100 day moving average of the equity put/call. I have highlighted those tops with a green box. The conclusion here is that the bears may have a lot more waiting to do before a top of any significance is observed. click chart to...
A FASCINATING INTERPRETATION OF THE VIX & PUT/CALL RATIOS: VOLUME 2
Notes are on the chart. Per the usual, conventional wisdom regarding these two indicators is way off base here. Moving averages only to provide a clean price picture. click chart to enlarge
A FASCINATING INTERPRETATION OF THE PUT/CALL RATIO: VOLUME 1
Those of you who have been following my postings for more than a few weeks know that I am fond of interpreting the put/call ratio as a means of gauging market psychology and spotting potential reversal points in the market. I have come up with many methods of interpreting the put/call ratio based on different studies relating to trend, seasonality, volume, mean reversion and length of time. I wanted to share one study as it pertains to the current market environment. I have determined that not only is it important to look at the levels of the put/call ratio but the characteristics the indicator exhibits as it moves up and down through different phases of the market. I use varying moving averages only for my put/call studies. The raw data is too erratic and needs to be averaged out over periods of time. The studies are always a work in progress. The more I investigate them, the more nuances I find in seemingly straightforward data points. One recent discovery is that extreme levels of pessimism as measured by the put/call will obviously have different rates of reverting back to their means once sensibility returns to the market. The rate of reversion can give important clues as to the intention of the market. It makes perfect sense too. If participants are jaded enough by the recent price action, they will take their foot off of the put buying pedal but will be hesitant to go full steam into buying calls. This causes the moving averages of the put/call ratio fade slowly over a period of months instead weeks. On the other hand, if market participants are optimistic about a recovery, the reversion of the moving average will take place much more quickly. This opens up the market to weakness much earlier than the former example since market participants are loading up on calls while shunning puts, thinking that the worst is indeed behind us. In a majority of the cases, the reversion of the put/call ratios takes the speedier route, most often not taking anymore than 3 months to hit the fateful 25% reversion (20 day MA) from the high mark. I have found that between 22% and 25% reversion is where the greatest potential for the market to begin showing weakness lies. That is UNLESS the reversion takes longer than 3 months. If the 25% threshold takes longer than 3 months to meet, then market weakness seems to start at a much later date. The markets basically continue grinding up right through the bullish sentiment. Here are three of the most recent examples in 2004, 2006 and 2010. The...
PSYCHOLOGY CREATED THE OCTOBER BOTTOM AND NOW IT’S CREATING A JANUARY TOP
Significant market tops and bottoms are psychological events...nothing more. When I put a majority of my cash to work in leveraged long ETFs at the October 4th bottom it wasn't due to any fundamental data or statistical insight whatsoever. It was purely a trade that came from knowing that the market HAD to rebalance the longs and shorts before it was able to resume the downtrend. The job of the market in rebalancing the sentiment is nearly complete. Bears are diminishing in numbers and bulls are growing more bold in their conviction that the October lows are as bad as it gets. With that said, the second phase of the bear market will begin in short order. Here are two charts demonstrating the challenges and intentions of the market at this juncture: click chart to...
HOW THE ADJUSTMENT BUREAU WITHIN THE FINANCIAL MARKETS IS CONSTANTLY WORKING AGAINST YOU
Between kids, work, and decompressing at the gym, I get the opportunity to watch a movie once in a great while. The Adjustment Bureau, while being an average movie, involved a concept that I found to be fascinating. Essentially the premise is that there is a secret society of super-humans that belong to a bureau that makes sure you remain in line with your pre-determined path in life. In order to keep you on that path, there are ripples in consciousness that take place to adjust your behavior along the path you are supposed to be on. The more you deviate from the path, the more drastic the means to shake you into being on the correct path (good or bad) become. This is a fantastic premise to apply to the financial markets. In trading and investing, the market makes a conscious effort to create ripples in your consciousness to affect future decisions. Take for example the volatility both up and down that took place on Thursday and Friday. The effect of such a move on the consciousness of a bearish market participant is substantial. The ripple in consciousness becomes apparent the next time a large move down occurs. It will become more difficult for that bearish trader to allow his profits to run as he has seen the disastrous consequence of the last time he attempted such a feat. Bear in mind that allowing profits to run is fundamental to trading. It is the absolute correct way to trade. However, the market has now caused a ripple to occur causing you to doubt yourself and the most fundamental of trading rules. Whereas in the film The Adjustment Bureau had both good and bad intentions for a person, the Adjustment Bureau that functions within the market has only bad intentions. In fact, it can become profitable to investigate how the market is attempting to infiltrate your consciousness in order to throw you off the correct trade. When the market is constantly attempting to infiltrate the consciousness of one side of a trade, I know that odds strongly favor a large move occurring in the direction of those the market is attempting to manipulate. The ripples in consciousness occur on a daily basis and they are furthered through the mass of information that is at the fingertips of every trader on the planet. Every piece of information you digest places a small token within your consciousness that will effect future decisions. Every move that the market makes whether in your favor or against you also places a token with your consciousness that will cause ripples in consciousness that influence future trades. The good traders know themselves well enough and...
BEARISH PSYCHOLOGY WAS PULVERIZED THIS WEEK
Is it better to be a fastball hitter or an expert at hitting curve balls? I'll start today's note with that question. It's a question that I've been asking myself following what was an obvious curve ball thrown at me by the markets yesterday. If I was to go back and look at Thursday's trading session from a completely blind perspective, I can't stay that I would have done anything differently. Friday was essentially at the bottom of the totem pole in terms of probable events. I'm not here looking for one day swings to take profits. I am looking for short-term trends to turn into intermediate trends that develop into outsized gains. These types of snap backs, fake outs or whipsaws are a part of the game. Nobody ever said that she would jump into the sack with you after her first bite of Filet Mignon (or Big Mac depending on your social status). It's not supposed to be easy. The question now becomes how to handle the portfolio going forward? Although I was down slightly for the week after giving up some substantial profits from Thursday, it was admittedly an emotionally taxing week. I only recently took on bearish positions this past week. If I am feeling as annoyed at being a bear during Santa season as I am, I have to wonder how the majority of bears who got sucked into the Fed liquidity gap of last week and the weekend gap before that must be feeling? I can't imagine that many of them, if any, are still sticking around. Days like yesterday, where hope quickly turns to despair for a certain group of investors, are the most significant of all. Every uptick from this point forward is akin to a 280 pound linebacker that can bench press a double wide coming at the bears in a full sprint. In other words, the game just became a lot more frightening for one team. Keep that type of psychological picture in mind should the squeeze progress further. That is what reversals are made of. At the end of the day, risk is risk is risk. And regardless of any brilliance that I bestow through my keyboard and into your home or office, my job and yours is to manage risk. Without risk management any assessment that I make is subject to the market demons that appear 1 out of 100 incidences, devouring you from within and taking your kids college keg and beer pong money with them. With that said, I know exactly at what price point my thesis is no longer valid. It is at that...
ANTICIPATION VERSUS REACTION
*This is the weekly email sent to investors. I will publish this on the website from time to time. There is no reason to deviate from something that has been working brilliantly well since the beginning of October. It has allowed me to look far smarter than I really am in anticipating and capturing a majority of this historic rally since October 4th. The correlation between the bottom and subsequent rally of 1998 and the current bottom/rally of 2011 continues to prove noteworthy. The study confirmed that the second leg of the rally kicked off on Friday of last week. Also confirming that we would rally through this week. The second leg of the rally gained roughly 4.5% in 1998. For this week we have gained 3.8%. The study tells us that we are about to embark on a sideways consolidation with a hint of weakness over the next week. In my experience with these studies, I have found that they are prone to breaking down during periods of market consolidation or pullbacks more than any other time. There will come a time when this study stops working completely. The market cannot remain so highly correlated to any previous period for very long until it begins moving down a completely different path that forces us to search out a new road map for profit. The last few days of the month have had a tendency to be strong during 2011. The month of October has not deviated from that path. The opposite is true, however, for the first few days of a new month. The tendency during 2011 has been to see the new month bring in the desire to take profits or further sell positions off. I don't expect November to deviate from that trend. From a psychological standpoint, we have seen a significant change in the mentality of investors as the markets are beginning to force people away from their preconceived tendencies towards bearishness. What we have currently is a cautiously bullish outlook for the markets. This outlook has been created purely out of reactive behavior to prices rising. The markets often times punish reactive behavior. They will, however, reward anticipatory behavior. Anticipatory behavior involves investors looking for points in the market when the lights are off, the room is dark and the only sound that can heard is that of frightening screams and terror. October 4th was one such instance. There was no perceived security in buying that point. In fact, it was the most frightening time of all. Anticipation of a bullish outcome in the face of absolute fear was indeed rewarded. Reactive behavior involves...
BLOOMBERGS SELECTION OF VIDEOS TODAY
A picture speaks a thousand words. The blind leading the...
FOR THE FIRST TIME IN OVER 2 MONTHS…..
I've taken on long side exposure relating the US equity markets. I initiated a position in FAS on Friday at roughly 10.50. It's the smallest position in the portfolio for the time being. I may add in the near future. Depends on what I see, hear and smell in the coming days and weeks. In my article from 9-22 entitled "Black Clouds and Traumatic Memories", I briefly discussed a discounting mechanism that I believe is apparent in the marketplace currently and is receiving very little mention. The traumatic events of 2008 undoubtedly left lasting mental scars amongst the majority of professional investors that currently dominate Wall Street. The relatively short amount of time between the 2008 crisis and the current crisis - not to mention the similarities - are causing investors to face the same fears as they did in 2008. Given the flashbacks and propensity for survival amongst those who are making vast sums of money, you can be assured that fund managers are taking every step necessary to make sure that they don't lose a source of income that will be impossible to replicate should the market repeat the events of a few years ago. In other words, risk has been taken off completely and totally in the name of job security. Given this set of circumstances how much of a repeat of 2008 fear discount is being factored into the markets currently? Even more importantly, how much of a repeat of 2008 fear discount is being factored into the financial sector currently? After all, the financial sector is what was behind the events of 2008. The financial sector caused massive wealth destruction amongst those who thought that Lehman and Bear going down was an impossibility. The financial sector became the poster child for over-leveraging and lack of oversight or perhaps lack of understanding with respect to fundamental truths about markets. There is no sector that is as negatively influenced by this discount as the financials. With that said, the greatest potential for mispricing and therefore, most significant upside is in the financial sector. You can study the balance sheets of JP Morgan (good luck with that if you try, by the way), Goldman, Bank of America and Citi until your eyes falls out and bounce around your desk. It's not going to take into account the core reasoning behind all price movement: Emotionally driven aspects of human psychology that depend on monetary fulfillment in order to derive a sense of security to further cultivate the fundamental motivation behind all living things - procreation. A subject for another article. Once fear gives way to rationality, it will...
MISERABLE? ZOOM OUT, GET A GRIP AND BLAME THE MACHINES.
The only thing that changed with Friday's smash reversal to the upside was the near term prospects for continued upside volatility. This market isn't for the meek or emotionally fragile investor. I see a majority of financial bloggers out there who are so zoomed in short-term price movements I wonder how they make it past breakfast on a daily basis. They are literally providing small drops of noise into a sea of loud screams. It is a well known fact that we are in a market that is dominated by HFT (high frequency trading). You have powerful computers that are being programmed by that kid with glasses you sat next to in elementary school that was better than you at everything and anything that had to do with numbers. What the HFTs have done is take even the most sophisticated trading systems and turned them into mush. They know what systematic traders are going to do 20, 30 even 50 steps ahead. It makes technical traders who try to gauge every movement in the market all the more irrelevant. It is more imperative now more than ever to take the following two steps: 1. Zoom out when you look at price movements. Weekly, 9 day or monthly charts only. 2. Be emotionally stable. You have to be able to deal with the volatility. It is the new normal in the markets and it is only getting worse. If you can't, then you need to reduce your positions or get out of the market completely. All that I'm seeing out of traders in the current environment is a stance that is either market neutral with equal parts long and short positions. Or taking small 1-2 point profits here and there, without regards for the larger move in the markets. It seems that a large number of investors have simply turned to the markets as a way to satisfy their lust for entertainment Monday through Friday, while ignoring the primary purpose of the markets -- to create wealth. You don't create wealth by being market neutral and you don't create wealth by jumping in and out at the first sign of ghouls and goblins. Wealth is created with the large moves that take guts, perseverance and vision to stick to until the investment realizes its potential. Find the path of least resistance, position yourself appropriately and sit tight. That's what I have done. I may reduce some short exposure here and there, but my core positions are there to stay. Managed appropriately, I expect to be profitable in the near, intermediate and long-term. There's a lot of noise out there. Blinders...