Market Commentary

Traders are often confronted by mixed signals. 

Personally, when I have to choose between something straightforward or something complex – I remember the phrase "simple is better".

For example, when large "Smart Money" traders show their directional bias, it often pays to follow in their tracks.

Another technique would be to bet against the smaller retail "Dumb Money" traders (because historically they are often wrong at major turning points.

However, if I have to decide between following "Smart Money" or doing the opposite of what "Dumb Money" does … then in the absence of other information, following Smart Money wins because it is more straightforward and simpler.

Here is an example.

Retail Investor Are Putting On Their Bear Suits.

"Small traders" are showing extreme pessimism by buying a very low percentage of call options (bullish bets) compared to the total options purchased. 

As a reminder, many traders consider excessive bearishness from small investors a sign that markets are set to go higher. This is considered a contrarian buy signal. The question is whether it is a reliable buy signal? 

Over the last several years when this number gets below 30%, the market was at, or near, the start of another significant push higher. Here is a chart.

Something to consider is that the crowd is often wrong at major turning point because they are too bearish before a big push up (or too bullish before a big push down).  Here, we may have a different situation.  Small investors have lost confidence even though the markets are near recent highs.

Before we look at what larger "Smart Money" investors have been doing, let's look a little deeper into the Put/Call Ratio.

What Does the Put/Call Ratio Measure?

A Different Put/Call Ratio Suggests that Smart Money Is Looking for a Pullback.

Unlike the CBOE Total and Equity Put-to-Call ratios, the OEX Put-to-Call Ratio is not considered a contrarian indicator.  Why?  Because OEX options are normally traded by larger "Smart Money" traders. 

Likewise, there is more put buying in the OEX because OEX options are one of the instruments that large money managers use to hedge their portfolios.

To put things in perspective, historically, Smart Money traders buy 100 to 150 puts per 100 call purchase.  Consequently, a ratio hovering around 1.50 (150 puts purchased/100 calls purchased) is pretty normal.  However, you must take notice when Smart Traders are buying puts hand over fist.  Last week the Smart Money traders bought a little more than 3 puts per 1 call, closing the OEX Put-to-Call Ratio at 3.36.

ZorTrades posted this chart.  It shows how often a high OEX Put-to-Call Ratio results in a market downturn. Click the image to see a larger version.

This chart marks the times where the OEX Put-to-Call Ratio has closed above 2.40 (meaning that Smart Money was buying more than twice the amount of puts than calls).  As you might guess, the outcome has not been pretty when this has been the case.  Notice above that 6 out of 7 occurrences resulted in significant moves down.

As my Dad used to say: "You can fool everyone some of the time; but you can't fool all of the people all of the time.  Perhaps the small trader isn't always wrong?  And, perhaps, simple is better.

Traders are often confronted by mixed signals. 

Personally, when I have to choose between something straightforward or something complex – I remember the phrase "simple is better".

For example, when large "Smart Money" traders show their directional bias, it often pays to follow in their tracks.

Another technique would be to bet against the smaller retail "Dumb Money" traders (because historically they are often wrong at major turning points.

However, if I have to decide between following "Smart Money" or doing the opposite of what "Dumb Money" does … then in the absence of other information, following Smart Money wins because it is more straightforward and simpler.

Here is an example.

Retail Investor Are Putting On Their Bear Suits.

"Small traders" are showing extreme pessimism by buying a very low percentage of call options (bullish bets) compared to the total options purchased. 

As a reminder, many traders consider excessive bearishness from small investors a sign that markets are set to go higher. This is considered a contrarian buy signal. The question is whether it is a reliable buy signal? 

Over the last several years when this number gets below 30%, the market was at, or near, the start of another significant push higher. Here is a chart.

Something to consider is that the crowd is often wrong at major turning point because they are too bearish before a big push up (or too bullish before a big push down).  Here, we may have a different situation.  Small investors have lost confidence even though the markets are near recent highs.

Before we look at what larger "Smart Money" investors have been doing, let's look a little deeper into the Put/Call Ratio.

What Does the Put/Call Ratio Measure?

A Different Put/Call Ratio Suggests that Smart Money Is Looking for a Pullback.

Unlike the CBOE Total and Equity Put-to-Call ratios, the OEX Put-to-Call Ratio is not considered a contrarian indicator.  Why?  Because OEX options are normally traded by larger "Smart Money" traders. 

Likewise, there is more put buying in the OEX because OEX options are one of the instruments that large money managers use to hedge their portfolios.

To put things in perspective, historically, Smart Money traders buy 100 to 150 puts per 100 call purchase.  Consequently, a ratio hovering around 1.50 (150 puts purchased/100 calls purchased) is pretty normal.  However, you must take notice when Smart Traders are buying puts hand over fist.  Last week the Smart Money traders bought a little more than 3 puts per 1 call, closing the OEX Put-to-Call Ratio at 3.36.

ZorTrades posted this chart.  It shows how often a high OEX Put-to-Call Ratio results in a market downturn. Click the image to see a larger version.

This chart marks the times where the OEX Put-to-Call Ratio has closed above 2.40 (meaning that Smart Money was buying more than twice the amount of puts than calls).  As you might guess, the outcome has not been pretty when this has been the case.  Notice above that 6 out of 7 occurrences resulted in significant moves down.

As my Dad used to say: "You can fool everyone some of the time; but you can't fool all of the people all of the time.  Perhaps the small trader isn't always wrong?  And, perhaps, simple is better.

Despite some early selling, the Bears were not committed their positions – and prices held up well again last week. Going into the long Memorial Day weekend, it didn't make much sense for Bears to press their bets without a selling catalyst.

Still, the mood seems 'gloomy'. 

The S&P 500 is down less than 3% from its recent closing high.  Nevertheless, based on the latest sentiment figures from the American Association of Individual Investors (AAII), you would think a lot more damage had been done.  Bespoke reports that Bullish Sentiment is at its lowest level since August 2010, and a far cry from the 60%+ levels we saw as recently as February. 

If you have contrarian instincts, you've got to be bullish right now.  Remember, a few bulls is enough to push things higher if there are even fewer bears willing to press their bets.

A Public Service Reminder From the Bear's Den.

Of course, not everyone is a contrarian.  Some see smoke and warn of fire. 

With that in mind, here is a list of the 7 major risks David Rosenberg sees brewing:

1. China hard landing (PMI down to 51, perilously close to contraction mode)…equity market may have begun to price in some probability of such.
2. Contagion sovereign credit risks in Europe (the rating agencies have already begun to take action against Spain, Italy and Belgium).
3. Countertrend rally in the US dollar – this is crushing the risk-on carry trades: the unwinding of net speculative short positions in the dollar and long positions in the Euro seem to have further to go based on the latest CFTC data.
4. Deepening recession in Japan – still one of the world’s largest economies; spill-over on global production schedules still to be felt.
5. US fiscal policy is becoming more radically austere at all levels of government.
6. The end of QE2 will be a very big deal given the 89% correlation between the Fed’s balance sheet and the movements in the S&P 500 over the past two years.
7. US leading economic indicators are rolling over.  The Conference Board Index fell in April for the first time since June 2010; the coincident-to-lagging indicator is down three months in a row; and the ECRI smoothed index is down now for four straight weeks, a streak last seen in July 2010.

Source: Gluskin Sheff (with a hat tip to Pragmatic Capitalism)

Despite some early selling, the Bears were not committed their positions – and prices held up well again last week. Going into the long Memorial Day weekend, it didn't make much sense for Bears to press their bets without a selling catalyst.

Still, the mood seems 'gloomy'. 

The S&P 500 is down less than 3% from its recent closing high.  Nevertheless, based on the latest sentiment figures from the American Association of Individual Investors (AAII), you would think a lot more damage had been done.  Bespoke reports that Bullish Sentiment is at its lowest level since August 2010, and a far cry from the 60%+ levels we saw as recently as February. 

If you have contrarian instincts, you've got to be bullish right now.  Remember, a few bulls is enough to push things higher if there are even fewer bears willing to press their bets.

A Public Service Reminder From the Bear's Den.

Of course, not everyone is a contrarian.  Some see smoke and warn of fire. 

With that in mind, here is a list of the 7 major risks David Rosenberg sees brewing:

1. China hard landing (PMI down to 51, perilously close to contraction mode)…equity market may have begun to price in some probability of such.
2. Contagion sovereign credit risks in Europe (the rating agencies have already begun to take action against Spain, Italy and Belgium).
3. Countertrend rally in the US dollar – this is crushing the risk-on carry trades: the unwinding of net speculative short positions in the dollar and long positions in the Euro seem to have further to go based on the latest CFTC data.
4. Deepening recession in Japan – still one of the world’s largest economies; spill-over on global production schedules still to be felt.
5. US fiscal policy is becoming more radically austere at all levels of government.
6. The end of QE2 will be a very big deal given the 89% correlation between the Fed’s balance sheet and the movements in the S&P 500 over the past two years.
7. US leading economic indicators are rolling over.  The Conference Board Index fell in April for the first time since June 2010; the coincident-to-lagging indicator is down three months in a row; and the ECRI smoothed index is down now for four straight weeks, a streak last seen in July 2010.

Source: Gluskin Sheff (with a hat tip to Pragmatic Capitalism)