This has been an extremely dramatic decline, from 22 to 13.9 in one trading week.
Previous drops under 14 in recent years have been followed by limited upside in stocks and an increased incidence of significant declines.
This week’s action seems to be based on relief that Congress has come to terms on the budget. Never mind that taxes are going up for everyone (payroll tax “holiday” ends), and that no progress was made on spending, not even so-called “cuts” to the rate of growth.
Side note on the budget:
High inflation remains baked into the cake for the coming years, just as it appeared in the later years of the secular bear markets of the 1910s, 1930s-40s, and 1966-1982. This is not just because the government is running trillion+ deficits without end, because the Fed has tripled its balance sheet and the monetary base in just four years.
When enough bad debt has been written off for lending to start back up in earnest, the upswing of the multi-generational interest rate cycle will have severe repurcussions for the budget. The effects will be greater because the US Treasury is not taking advantage of low long-term rates, but issuing mostly shorter-term notes.
Note that I was a rare bull on Treasuries going into the last debt crisis. That is no longer the case, but I’m not necessarily bearish on them just yet.
Even if this is just a small correction in a continuing rally (which it is very dangerous to assume), the market has a lot of room left to shake things up. The 20-day average equity put call ratio is still at an extremely suppressed level:
Here is the raw data since 2004, the last time we saw such a low running average of CPCE. Stocks went nowhere for about a year after that. They should be so lucky this time…
Such long-running lows must be balanced out with more than a bit of fear. One other thing that is noteable in this chart is how the Panic of ’08 only produced marginally higher put:call readings than the stagnation of ’04.
The put:call ratio, the best timing indicator I follow, bar none, is giving a screaming sell signal. Are there any bears left to take it?
No strong conclusions here, just some food for thought:
You can also see a possible 30-day pattern: 30 days down, then a ramp. Let’s put this in perspective. Here’s a 5-year weekly chart. All I can note here is a divergence on the RSI over the last few months:
I’ve also noticed how Treasury bonds have resembled the VIX for some time (I put in those RSI buy/sell signals just for fun — not as effective here as in the 60-min chart of Dow futures, but not bad either):
Just goes to show, when you think you’re trading US stocks, Chinese stocks, commodities, bonds and options, you’re really just trading global patterns of fear and greed. It doesn’t matter what market you choose these days. They’re all the same.
The 5-day average equity put:call ratio is now right at the mean:
You can see that the 20-day average still has a long ways to go, which means that the 5-day is likely to spike well over the mean in the next wave (a 3rd wave?) down. I’m looking for summer 2007 conditions to counter the extreme complacency that we’ve had since August, which suggests that we have another 5-10% on the downside in this move after any countertrend bounce from here exhausts.
As far as that anticipated bounce goes, the VIX also threw its hat in the ring, offering a buy signal by closing back within two standard deviations of its 20-day average.
Gee, who would have thought?
Here’s the trusty 5-day trailing average equity put:call ratio as of Thursday’s close (for some reason, indexindicators doesn’t update this until the next morning). CPCE doesn’t give sell signals like last week very often, but when it does, SELL! BTW, Friday’s closing CPCE print was 1.05, so this thing has really rocketed up now.
This translates into some serious price changes, even on long-term options. The SPY 90-strike December 2011 puts I favor are up 40% in just a few days. I’ve also written a whole bunch of March-Sept 2010 calls on stuff like QQQQ and DIA. That’s a great way to make some income, since even if the market doesn’t crash, so long as it doesn’t keep blasting upwards the time decay is money in your pocket.
UPDATE. Here’s the chart as of Friday’s close. I bet we don’t bounce hard until the 5-day average gets at least 1SD above the mean. And look at the swiftness of this week’s drop in SPX… this is a more powerful decline than any since last winter.
I have been watching the parallels between the last few months and the first half of 2007, and they are still very close. The late June – early July 2009 drop lines up with the late Feb – early March 2007 correction. In each instance, the markets then ramped up, then zig-zagged higher still as the put:call ratio oscillated at a low level. The final euphoric highs of July ’07 (when Chuck Prince said he was “still dancing” and Paulson said he had never seen such strength in the global economy) were marked by a brief lower low in CPC, which further compressed the springs for a stunning spike in fear as the equity markets cracked and Cramer threw a fit.
The crack here is likely to be even more violent, since everyone knows deep down just how bad things really are in the economy. It won’t take more than a shift in psychology to get people focused on the problems again, which are now fully developed, not just vague fears of some temporary “liquidity” issue in obscure debt instruments.
The CPC does not linger at under 0.55. Caution is creeping in already, as yesterday CPC made a higher print and the VIX, Russell and Nasdaq failed to confirm the Dow’s new high. The commodities complex may also be stalled out, and the dollar has corrected enough to continue far higher than in December. This time, the stars are aligned for an “all the same markets” rush to safety. Even Treasury bonds have sold off enough to rally nicely:
Source: Yahoo! Finance
5-day equity put:call is at max-sell level and won’t be here for long:
The last 6 months are still similar to February – July 2007, with this dip looking like July.
The 5-day trailing average equity put:call ratio strongly advises selling stocks:
This average doesn’t stay below 0.55 for very long. This doesn’t mean that the indexes can’t squeak out new highs for a few more days, and it doesn’t mean they have to crash, but it does mean that a decline of at least a few percent is extremely likely to start with a couple of weeks.
Jason Goepfert of Sentimenttrader.com posted this chart of the American Association of Individual Investors bullishness survey on his blog:
When everyone is on one side of the boat, stroll over to the other. In my opinion, at $6.00 each, December 2011 SPY 90-strike puts are just sitting there on the floor like $20 bills. The December 2012s are also now listed – the 100 strike is under 12 bucks today.
Everywhere I look this morning I see spikes in risk assets: copper, silver, oil, the pound, stocks, credit, etc. Copper and oil are moving tick for tick in lock step at the moment. These really are all the same market.
I recently read about a strategy whereby a trader would start “trading campaigns” 25k to risk on very high payoff black swan events. If his first short-term options trade was a winner, he would do another with the proceeds, and if that trade also worked, one more, for a total of three trades. The math can actually be highly favorable for of such a strategy, since for a good timer, the payoff can be dozens of times the initial capital. All you need is one winning streak in 10 or so campaigns to come out way ahead. This trader had attempted 9 such campaigns, 7 of which were 100% losers, 1 of which was flat, and one of which was a 60-bagger. He had socked away the proceeds from the 60-bagger, and was still trading 25k at a time. I’m not saying I’ll adopt this method, but it makes a good point about humans’ tendency to underestimate and underprice the probability of large moves, as well as their irrational risk aversion when it comes to the possibility of losing 100% in any one trade.