Trader’s Narrative

As the bulls and bears thrash it out at the knife edge of technical support, otherwise known as the 750 line on the S&P 500 index, the CBOE volatility index (VIX) is surprisingly calm:

As more and more days go by with the market dancing on the thin line marked by the November 2008 lows and the VIX staying much lower, the divergence gets more and more attention. In fact, the VIX has not even been able to muster a challenge to its January highs of 57. Like most indicators, this divergence can be interpreted several ways, depending on your existing bias.

Bullish
If you happen to already have bullish tendencies, then you’ll probably interpret this circumstance to mean that the market is healthy since this is the classic ‘bullish divergence’ in technical analysis. Also, back in October 2008 when the VIX first hit 80 (and beyond) that didn’t mark a definitive bottom - so why should be expect a high VIX reading at those levels again to have similar significance?

Bearish
If you happen to be a bear, then you’re probably thinking that the VIX must, at some point, be forced to revisit the highs it reached back in November 2008 before the market can truly find a lasting low. After all, if the VIX is so low (relatively speaking) that must mean that the options market is complacent. And no real bear market can be killed by complacency.

Personally, I’m not sure what to think. We are in a very strange market and it is fascinating to watch. But beyond that, if pressed I would slightly shuffle over to the bullish camp.

The CBOE volatility index is calculated based on the options market - which has been absolutely bonkers. By that I mean that it hasn’t followed the usual historical patterns. Over the past few months, I’ve struggled to make sense of it but I keep returning to just shrugging my shoulders and thinking that the options market has gone crazy.

What do you think is really going on? what does the VIX divergence mean? and the eccentricity of the options market?

Here is the sentiment wrap-up for this short but exhilarating trading week:

AAII
As I briefly mentioned yesterday, the weekly AAII sentiment survey shifted significantly. Optimists fell to 22% (a fall of 11% points) and pessimists weighed in at 57% of respondents - an increase of 18% points from last week. While this is a welcome from a contrarian perspective, it isn’t the lowest or even one of the lowest ratios we’ve seen historically.

Investors Intelligence
In contrast, according to ChartCraft, the editors for stock newsletters continued to shift restlessly, increasing a tiny amount in bearishness to 41.1% (and a small decrease in bullishness 31.1%). Not very helpful.

ISEE Options Sentiment
When the market broke the January lows on Tuesday (February 17th, 2009) and looked like it might not just approach but break through the November 2008 Maginot line, you’d imagine that the majority would be drenched in fear and grabbing all the puts they could get their hands on. But judging from the ISEE index, small time option traders are nonchalant about any such potential danger.

Take a look at the equity only ISEE data for the past few months (the higher the ratio, the more optimism it reflects):

Not only have they been buying more calls than puts (to open trades) during the harrowing but short trading week, this ratio actually went up on Tuesday’s wide range decline. The only consolation is that such puzzling behavior is par for the course, as option trading data has been continually befuddling during this bear market.

CBOE Put Call Ratio
The more traditional CBOE put call ratio (equities only) spiked yet again above 1.0 - but we’ve been here before. It does, however, dove-tails nicely with the OEX put call ratio which I mentioned last week.

StateStreet Confidence Index
This lesser known sentiment indicator reached its low late last year - reflecting the dire straits that managers found difficult to deny after the spike down in October and November. Since then the regional data for North America has more than doubled from 30.6 to 64.5. And the global confidence index has recovered from its ‘all time’ low of 48.2 to reach 72.9 - which would imply that the average money manager out there is now back at the risk buffet. But remember that since the StateStreet confidence index is still a relatively new indicator, the best prescription is to take it with a truckload of salt.

Volatility
While the market is once again at the knife’s edge, the VIX volatility index is surprisingly low. While it did gap up on Tuesday, the VIX is still meandering around the 50 level - far from the 80 double peak in October-November 2008. This is less a separate confirmation of any sort and more a corollary of the crazy options market we’re seeing.

Here’s a quick recap of this week’s sentiment analysis:

AAII
Last week the retail investor’s sentiment as measured by this survey was almost perfectly balanced. This week’s results push the bulls ahead with 39.73% of respondents and the bears at only 35.62%.

According to Wall St. lore, a bull market climbs a “wall of worry”. But according to these numbers, we don’t even have a pile of bricks.

Investor’s Intelligence
From ChartCraft’s sentiment survey of newsletter editors taken on December 16th, 2008: the bulls continued to tip-toe up, reaching 26.9%, while the bears were little changed (albeit up slightly) to 47.3%.

The important thing is that we aren’t seeing what I’d ideally like to see: a resounding pessimism, even in the face of a rebounding market. That makes it difficult to believe we won’t see some sort of weakness ahead.

ISEE Sentiment
Tuesday’s big up move pushed the ISE sentiment index (equity only) all the way up to 176. Which means that on that day, 176 calls were traded (to open) relative to 100 put trades. That is a tad high, definitely above average for the year, but not extremely high.

For the most part, the ISE is stuck in a frustratingly tight trading range. So far it has refused to show any real signs of fear, even during the most hair raising down days of this harrowing bear market.

CBOE Put Call Ratio
While I have bemoaned the crazy options market behavior lately, I decided to have another go at it. This time, I stepped back and looked at the 14 day moving average of the CBOE put call ratio (equity only). Surprisingly, things look much saner through this filter:

Volatility Collapse
Finally! Volatility has collapsed and not a moment too soon. I was afraid my crystal ball was getting foggy. Turns out all it needed was a formidable double top from historic highs:

Here’s a quick recap of the sentiment data for the past week:

Sentiment Surveys
We are finally seeing some initial bullish patterns emerge from sentiment surveys. I mentioned repeatedly that what I would prefer to see was a situation where the sentiment would become more bearish as the market rallied. Until this week, we had seen a quick about face in sentiment with many jumping on any rally and switching from pessimism to optimism. But this week provided a slightly different take on this.

The Investor’s Intelligence which monitors newsletter editors showed bulls decreasing almost 6% points to 23.1% and bears increasing almost the same amount to reach 49.5%. While the number of bears is down significantly from its peak at 55% in November, what is encouraging is that this slight increase in bearishness corresponds with strength in the stock market.

Similarly, the AAII sentiment released this week shows that bearish sentiment increased 3% points to 48% and bullishness decreased 4% points to 27%. The weekly survey comes out on Wednesday, which means that while the S&P 500 is at a slightly lower - almost equal - level (850-860) to last week, sentiment has definitely soured.

This is a good sign, from a contrarian point of view. However, I don’t want to get too excited because it is just one data point. If we start to see a dispirited response to a continuing rally, in the coming weeks, then it will be a tell tale sign that the rally will stick. Otherwise, if we again see sentiment do an abrupt about face, we’re headed down (again).

Options Market
Here is a chart of the equity only ISE Sentiment Index showing the contraction that I pointed out a while ago is still continuing:

I’m not sure what this means. Perhaps the ISE has simply changed and is no longer able to provide the same signals because there has been a fundamental change in the participants. Or maybe there is another explanation? Any ideas?

The traditional perspective on put call ratios from the CBOE continues to be ambivalent, at best, and downright confusing at worst.

A little late due to a break over Thanksgiving holidays, here is a quick recap of the sentiment landscape for the week:

ISEE Sentiment
The equity only call put ratio from the ISE closed last week at 149, after reaching a high on Thursday of 163. Those readings are just too high to allow for a real bottom to unfold. They show an almost total lack of fear from the retail options traders. And as I showed before, there is a peculiar contraction in the range of ISEE sentiment. We are simply not seeing the wild swings which etched the emotional highs and lows of traders as we used to. What this is due and what it means, I have no idea.

CBOE Put Call Ratio
The equity only CBOE put call ratio was pushed down to 0.56, the second lowest level for the whole year. The lowest was 0.51 in September 2008. That is a lot of complacency. But then again, the options market has not been acting “normal” so it is difficult to interpret it right now.

AAII
The retail investor’s sentiment, as measured by the AAII became significantly more bullish. AAII bears fell to 45% and bulls rose to 31%. This isn’t all that surprising since the survey was taken after the sharp rally that took the S&P 500 ~150 points. But it is disappointing from a contrarian point of view. Had we instead seen a reluctance to believe the rally, then it may have been much stronger.

Investor’s Intelligence
The newsletter editors’ sentiment was little changed: bulls fell slightly to 29% while bears rose slightly to 44%. Not a change that warrants any analysis or carries any portent.

Easy Come, Easy Go
Just to show how steep this recent counter rally was, consider that in mid November there were zero S&P 500 stocks which closed above their short term 10 day moving average. By the end of last week, there were almost 90% which closed above the same. Of course, that was followed by Monday’s crushing fall in all indices.

If you haven’t yet, read my notes from a recent presentation by Lowry Research. Also download the relevant documents from the free trading resource section to follow along with the charts (Reports & Articles folder).