The end of quarter tape painters should be proud. They managed to push the Dow to within nine points of its January 2000 all time high at 11750. This pushed the Dow's gains for Q3 to 4.7% and the best performance since 1995. The S&P posted its best third quarter since 1997 with a 5.2% gain. The Nasdaq ended the quarter with a 4.1% gain. The Dow transports failed to confirm the Dow industrials gains and lost -9.6% for the quarter. Unfortunately the painters ran out of paint Friday afternoon and the indexes slid back into the red. The decline was slight with the Dow ending only a few points below its highs.
Dow Chart - Daily
Nasdaq Chart - Daily
SPX Chart - Daily
The day started out well with the Chicago PMI jumping to 62.1 from last months 57.1. This was well over the consensus estimates of only 55.5. This was exactly opposite the trend we saw in the Philly Fed last week. Internal components of New Orders, Production, Order Backlog and Inventories all rose. The spike in new orders was significant with a gain of 7 points to 67.3. Prices Paid fell along with Employment, which fell sharply from 55.1 to 50.8. This unexpected strength in the Chicago manufacturing region suggests the national ISM due out on Monday may not be as bleak as analysts thought after the sharp drop in the Philly Fed survey. The current consensus is for a flat ISM at 54.0 for September. Over 50 is considered economic expansion and under 50 is a contraction. The PMI was met with surprise and also with a lot of disbelief. Many analysts thought it was an anomaly that would be corrected with next month's data. Time will tell.
The NAPM-NY also posted a gain for September but it was not as dramatic as the Chicago PMI. The NAPM rose to 421.0 from 416.8 but several internal components lost ground. The six-month outlook fell to 75.0 from 81.3 and the current conditions component fell to 58.5 from 65.0. This is not especially encouraging for traders. Inventory levels were up sharply with finished goods jumping to 67.0 fro 33.0. The NY NAPM has been climbing slowly for many months and the deterioration of those components follows the economic slowdown scenario and suggests next month could see a decline in the headline number.
Consumer sentiment rose from 82.0 to 85.4 in the final reading for September. The present conditions component fell to 96.6 from 103.8 but the expectations component jumped to 78.2 from 68.0. With gasoline prices dropping daily the fall in the present conditions component was surprising. Slower job growth was cited as a concern as well as the continued implosion in the housing sector.
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Personal Income rose 0.3% and right inline with consensus estimates but the core rate of inflation rose 0.2%. The Core PCE deflator, a primary concern for the Fed, showed a year over year inflation rate of 2.5% and the fastest core rate since 1995. The non-core PCE rose by 3.2%. The savings rate fell by -0.5% as consumers continue to be pressured by higher prices. The 0.3% growth in income was the slowest growth since last November. The slow growth in jobs is allowing employers to be choosy about their new hires and cheap when it comes to raises. Slowing income and rising inflation is not what the Fed wants to see. However, St. Louis Fed President William Poole spoke on Friday and repeated the Fed line that the worst was behind us. He also said that if inflation is only easing gradually there was no reason to hasten the decline by maintaining a restrictive Fed policy. He also said he would back a rate cut if both growth and price pressures were sufficiently weak over the coming months. However, nobody expects a rate cut or a rate hike for the rest of the year. The election cycle eliminates the October 24th meeting for political reasons and the next meeting is a week before Christmas and the Fed typically does not move around the holidays. Once into 2007 it is a different story with the majority of brokers now expecting a cut by the March meeting.
The calendar next week is chock full of major events led by the National ISM on Monday, three Fed speakers on Wednesday and the September Jobs report on Friday. The ISM is expected to be flat at 54 and a positive surprise there could be market friendly. A drop closer to 50 could create more fears about a hard landing and be market negative. Of the three Fed speakers on Wednesday Kohn is the one to watch. He is speaking on the economic outlook and does not have to remain as cautious as Bernanke in his comments. All the Fed speeches are at noon. The Jobs report on Friday is expected to show a gain of 125,000 jobs with whisper numbers rising to around 150,000. As long as the number is in those ranges everything will remain neutral and market positive. Over 150K is definitely not expected and could indicate a sudden and unexpected growth spurt in the economy, which could bring the Fed back into the picture. This would be especially true if the ISM surprised to the upside. A number slightly under 100K would be viewed as gentle economic slowing consistent with a soft landing. A number under 75K could cause alarm that the economy was spiraling down faster than expected and would be worse if the ISM fell several points as well. We already saw the GDP slip to 2.6% for Q2 and Q3 GDP due out in late October is expected to drop further to a range of 1.4% to 2.0%. The combination of all these events could produce some serious volatility next week.
Making news on the stock front was RIMM, which beat earnings estimates and guided sharply higher for the coming quarter. RIMM spiked $16.59 on the news and price targets from several brokers jumped by $40. The report was supposed to be released last Tuesday but it was delayed by their stock option review process. RIMM said it added 705,000 Blackberry subscribers during the quarter and expects to add another 800,000 in Q4. The new Pearl Blackberry is the company's first device targeted to the consumer market and expectations are very high. With an average volume of seven million shares RIMM traded 34 million at an all time high on Friday. I would be cautious of RIMM over the next couple weeks. That was a lot of people exiting on the good news. The new owners may have a low tolerance for risk at this level until we see some consolidation.
Merck (MRK) was watching nervously as a filing deadline for cases against its Vioxx drug approached. The deadline for filing cases is this weekend and more than 14,000 have already been filed. Some estimates suggest that number could hit 20,000 as those even remotely interested take a chance on a group payoff rather than litigate every case. Merck has been steadfast in their claims they will never pay and will fight every case. Unfortunately that would be terribly expensive and once the number of cases is capped we may see that stance changed to a class action payout.
Shutterfly (SFLY) and Bare Essentials (BARE) both came public on Friday and both ended the day with gains. Tech IPOs have done well recently as Riverbend (RVBD) and CommVault (CVLT) can attest.
FASB announced Friday a new set of reporting standards that will eventually cause extreme havoc in the stock market. The new standards require reporting of pension assets and liabilities on the company's balance sheet. This will provide another level of accountability for investors and illustrate the various problems the company may have with future pension obligations. According to preliminary estimates 47% of the S&P-100 will see their book value fall by more than -5%. 22% will drop by -15% and seven will drop more than -30%. The top five losers are probably companies you would have guessed with little effort. It is the amount of the drop that would surprise you with each company seeing their book value turn seriously negative. These rules will not take effect for sometime but you can bet the increased airtime from the rule change will create a drag on stock prices.
Negative Book Values
The Amaranth hedge fund announced late Friday that it was going to liquidate all positions and distribute the remaining funds to investors. Amaranth had tried to work a deal with Citigroup to generate some working capital in exchange for an ownership position in the company. That deal fell through on Friday and Amaranth announced after the bell it was shutting down once all positions were liquidated. Amaranth has several private equity positions that will require liquidation on a private offering basis and will take time to unload. Until it can do that they have suspended redemptions to keep extra cash for operating purposes as it liquidates. Amaranth had assets of $9.2 billion at the end of August and lost more than $6 billion in natural gas positions in only a matter of weeks. Unfortunately for Amaranth gas prices are poised to rally in October. Amaranth made $3 billion in profits in 2005. Big profits means big risk.
After the bell on Friday Keane (KEA) cut its earnings targets and fired the president of its North American Services division for misconduct. LCA Vison (LCAV) cut their expectations for the full year and announced the resignation of their president effective next week. LCAV dropped -$8 in after hours trading. A good rule of thumb is to avoid any stock that warns on a Friday night hoping to slip in unnoticed.
Oil prices continue to hover in the $63 range after a hard bounce off $60 earlier in the week. OPEC comments are starting to make the news with two members announcing voluntary production cuts to support prices. Nigeria said they would be cutting production by -120,000 bpd and Venezuela announced a cut of -50,000 bpd. This represents only 3.6% of the total production for those countries. Earlier in the morning OPEC had said it would be making an afternoon announcement about production cuts but Nigeria and Venezuela beat OPEC leadership to the punch. OPEC then cancelled their announcement. On Thursday there were rumors that an informal agreement had been made between Kuwait, Saudi Arabia and Nigeria to cut production. Nigerian oil minister Edmund Daukouru said he was unaware of any discussions on a joint cut. He told the Nigerian newspaper that consultations were still continuing among the 11 OPEC nations over what to do about the drop in prices. Obviously the mixed messages and flood of rumors is a sure sign OPEC members are concerned about prices and are willing to take steps to keep them from falling further. If you are OPEC sometimes you do not have to cut production but only act like cuts are imminent to achieve the desired result.
November Crude Oil Chart - Daily
November Natural Gas Futures Chart - Daily
Natural gas prices bumped up with the switch to the November contract and closed at $5.63 on Friday. There was another 77.0 BCF injection into storage last week and that pushed gas in storage to 3,254 BCF as of Sept 22nd and a 13-year high for this time of year. Assuming average injections for the rest of October we will begin the winter heating season, which starts on Nov-1st, with 3,543 BCF in storage assuming the storage locations can actually hold that record amount of gas. Because gas prices have been falling as storage locations fill up several gas producers have already started shutting in production rather than sell it for discount prices. Chesapeake Energy shut down 6% of their production or 100 million cubic feet per day and that will slow next week's injection rates. Chesapeake has more than 31,600 producing gas wells in the US. Other producers have said they would shut production below $5. Chesapeake has hedged 92% of its expected gas production at an average floor of $9.24 per mbtu. Obviously the price drop will not hurt them and by shutting in that portion not hedged they can wait for higher prices later this year. Ultra Petroleum and XTO Energy have done the same thing. Gas is going higher one way or another. September was 3.5 degrees cooler than normal producing expectations that this winter could be colder. However, forecasters claim El Nino is coming back this year and have predicted warmer weather for the southern US. These are the same forecasters that predicted a very heavy hurricane season for 2006 so I am not holding my breath. The Atlantic is still spawning storms with Isaac being the latest but all are headed north and well away from the oil fields. Whatever the outcome for weather it is unlikely we are going to have back-to-back record warm winters so expect some cold fronts to appear as usual. Once we start seeing inventory levels decline due to heating requirements natural gas prices will rise. Most analysts are expecting $7-$8 for a normal winter and over $10 if we suddenly start seeing North Pole conditions. The next couple of weeks may be a prime time to pick up some gas producers.
It was a banner month and quarter for the indexes if you believe the talking heads on stock TV. The major blue chip indexes rallied back to their highs and bulls were showing up on every corner. Personally I believe the rally was just a rebound since we were at these levels back in May before the summer crash began. We simply returned to the original levels. The fact that we did it in September is the amazing part given the history for the month. The problem now is of course October since it also has a record for major bottoms. I expect us to finish the year higher than we are now but I don't necessarily expect us to continue straight up. Friday's decline was not meaningful and it was expected. Over the last 26 quarters the last day was up only 25% of the time. The funds paint the tape into quarter end by keeping a bid under the winners hoping to go out strong. When there have been big gains the sellers are attracted to the last day like bears to honey. Those big gains are expected to evaporate next week and they want to be first in line. Friday was a textbook end of quarter event and nothing sinister should be read into the drop.
For next week we have several high profile economic events but Q3 earnings don't really kick into high gear until the week of Oct-16th. We will have a few earnings the week of the 9th but just a small sample. That means this coming week is warning week. Those companies who waited for the actual end of the quarter in hopes of an earnings miracle will have to face the music next week. That will give us some market news to digest along with the economics. Thomson is still predicting double digit earnings for Q3 and 13% for Q4. Those Q4 earnings are expected to be led by materials at 40%, financials 20% and industrials 17%. Laggards are expected to be utilities 4%, healthcare 3% and energy -2%. Energy has very tough comparisons with 2005.
Theoretically some funds will use next week to lighten up on their official Q3 statement positions to raise cash for future purchases should an October dip appear. My bias is slightly bearish for next week due to window undressing, potential earnings warnings and simply equalizing the overbought conditions. I think the economics could be better than expected and that would be a plus for the markets if that happens and a balance to those other negatives. Long term for Q4 I do expect a significant rally as long as the economy continues in slow growth mode. Historically the 4th quarter from the October lows produces above average double-digit gains for the S&P in the second year of a presidential election cycle. I would not bet on it happening but we can be prepared just in case.
The Dow rallied to 11741.67 to make the headlines but pulled back to close at 11679 on Friday. Support is weak at 11660 and a break there could quickly see us back at 11500 where we started the week. A move of that magnitude would be nothing to fear and that support at 11500 is fairly decent. It will depend on the external events for direction should 11500 be hit. Remember, this is the second longest streak on record (926 days as of Friday) without a -10% correction and it could happen at any time and triggered without warning by the slightest unexpected event. The longest streak was 1,767 days ending on October 7th, 1997. The key words there were "ending on October."
Russell-2000 Chart - Daily
Russell-2000 Chart - 15 min
The Nasdaq rallied about 60 points from Monday's lows but most of those points came on Mon/Tue. The rest of the week was spent in a narrow range from 2255-2275 with multiple swings. Techs were just not as excitable as blue chips. The SOX failed at resistance just over 460 and closed right on support on Friday. Warnings from several chip companies are weighing on techs in general. Since quite a few techs are small caps the performance of the Russell is always a support question. The Russell rallied 18 points to 733 by Tuesday but spent the rest of the week treading water only to collapse at Friday's close taking the Nasdaq with it. Support on the Russell is 715 and I would have no trouble imagining that level again early next week. Note in the table below that the Russell-2000 came very close to ending negative for the quarter with less than a point of gain. Normally the Russell is the strongest index going into year end but economic concerns are weighing heavily on small caps.
SPX Chart - Weekly
SPX Chart - 30 min
The S&P-500 rallied 30 points into Wednesday's open to tag 1340 and a new five-year high. Unfortunately that high became resistance and held like a brick wall the rest of the week. The close on Friday was negative but only to the tune of -3 points to 1335. The S&P was the best performer of the week and closed with the best relative strength. The game plan for the week was to remain long over 1315 and short below 1310. That gave us a dramatic rally and you should be long today at 1335 and ready for a new plan. Given the dead stop at 1340 that makes the plan very simple. Remain long over 1340 but reverse to a short or flat under initial support at 1333. If we do get an extended decline the 1310/1315 plan should be reactivated once those levels are reached. This is not complicated and nobody should make it any more complicated than it is. Having a dozen indicators and a myriad of shapes on your charts only gives you a good case of indecision. Monday's ISM at 10:00 should provide the spark for market direction and earnings warnings will provide the fuel. Just plan your trades and trade the plan and let the market make the decisions.
GlobalSantaFe - GSF - close: 49.99 change: 1.15 stop: 47.64
Why We Like It:
BUY CALL NOV 47.50 GSF-KW open interest= 278 current ask $4.30
Picked on October xx at $ xx.xx <-- see TRIGGER
Oil Service HOLDRs - OIH - close: 129.85 chg: 1.80 stop: 124.99
Why We Like It:
BUY CALL NOV 125.00 OIH-KE open interest=2460 current ask $9.90
Picked on October xx at $ xx.xx <-- see TRIGGER
Sears Holding - SHLD - close: 158.09 chg: -2.29 stop: 162.05
Why We Like It:
BUY PUT NOV 160.00 KDU-WL open interest=1006 current ask $8.60
Picked on October 01 at $158.09
Boston Properties - BXP - close: 103.34 chg: 0.88 stop: n/a
Why We Like It:
BUY CALL OCT 105.00 BXP-JA open interest=248 current ask $1.20
Picked on October 01 at $103.34
Google - GOOG - close: 401.90 chg: -1.68 stop: n/a
Why We Like It:
BUY CALL NOV 440 GOP-KH open interest=619 current ask $7.50
Picked on October 01 at $401.90
Cymer Inc. - CYMI - close: 43.91 chg: -0.66 stop: 41.95
The SOX was slipping back toward support at the bottom edge of its rising channel on Friday. The weakness in semiconductors was also felt in shares of CYMI, which declined 1.48% but volume on CYMI's move dropped significantly. Technically the stock looks somewhat overbought and the upward momentum has stalled. The MACD on the daily chart looks poised to produce a new sell signal yet the weekly chart's MACD has just produced a new buy signal. It may not matter but Friday's decline also saw the stock break down under its 10-dma and 200-dma, which is normally bearish yet shares are still holding above their five week trendline of support (rising lows). What does all of this mean? It means that the SOX and CYMI is at a pivotal level and next week should see either a breakdown under support or a bounce higher into the next leg up. We are not suggesting new positions given early October's historical weakness and more conservative traders may want to tighten their stops even further. Our target is the $47.00-48.00 range. We do not want to hold over the late October earnings report.
Picked on September 06 at $ 42.55
General Dynamics - GD - close: 71.67 change: -0.74 stop: 69.94
It's probably a good time to make a new decision on GD as a bullish call candidate. The stock was a winner for the third quarter but our bet that end-of-quarter window dressing would really push the stock significantly higher did not pan out. The overall pattern for GD remains bullish but momentum indicators are starting to falter. Right now our expectation is that the stock will dip back toward the $70.50-70.00 region. Whether or not it bounces from support near $70.00 is the real question. If you don't want to risk it then consider exiting early right now. We're going to keep the play open but we're not suggesting new positions right here. Our target is currently the $75-75 range. We do not want to hold over the mid October earnings report.
Picked on September 24 at $ 70.61
Mettler Toledo - MTD - close: 66.15 chg: 0.12 stop: 63.45
MTD closed out near its highs for the quarter. There overall pattern is bullish and the P&F chart looks very strong with a triple-top breakout buy signal and an $81 target. However, we are not suggesting new plays. Here's why. First the stock's rally failed last week near $66.30, which was resistance back on June 1st, 2006. Second, intraday indicators are suggesting the next move will be lower. Third, we have to face what is traditionally a weak period for stocks during the first half of October. We do want to remind readers that the $67.50-68.50 region appears to be the forecasted price target of MTD's inverse head-and-shoulders pattern formed from June through August. Currently our target is the $68-69 range. We do not want to hold over the late October earnings report.
Picked on September 13 at $ 63.66
Omnicom - OMC - close: 93.60 chg: -0.30 stop: 89.89
OMC turned in a strong performance last week with traders buying the dip near support around $90.00. Thursday and Friday saw a little bit of profit taking but it was minimal. The P&F chart continues to point to a $131 target. If the markets remain positive we suspect that OMC will challenge its June highs. However, we would wait for a dip and bounce near $92.00 before considering new positions. The $92 level was short-term resistance about two weeks ago so it's a natural spot to look for new short-term support. Our target is the $96.00-97.00 range. We do not want to hold over the late October earnings.
Picked on September 10 at $ 90.97
Caterpillar - CAT - close: 65.80 chg: -0.79 stop: 67.36
The DJIA's attempt at a new high got a lot of help from CAT. The stock reversed a bearish sell signal and produced a 4.8% rally last week. Yet in spite of its strength CAT could not breakout past its 50-dma or its bearish trend of lower highs. The P&F chart is still bearish with a $48 target. Friday's session looks like a failed rally near $67.00 and aggressive traders may want to open new put positions here. We are suggesting that readers wait for a new decline under $65.00 or even $64.50 before opening new plays. Our target is the $60.25-60.00 range but more aggressive traders may want to aim lower. We do not want to hold over the late October earnings report.
BUY PUT OCT 70.00 CAT-VN open interest= 2801 current ask $4.90
BUY PUT NOV 70.00 CAT-WN open interest= 7787 current ask $5.40
Picked on September 21 at $ 64.59
Chipotle - CMG - close: 49.67 change: 0.07 stop: 52.61
Shares of CMG traded sideways on Friday but if you look at the intraday chart you'll notice the afternoon rally attempt failed near the $50 level. This looks like a new entry point to buy puts. Last week the stock's bounce from the $50 region stalled under its five-month trendline of resistance. The subsequent breakdown under the 50-dma and the $50 level appeared to be an entry point to buy puts. Our target is the $45.50-45.00 range. We do not want to hold over the late October earnings report.
BUY PUT NOV 50.00 CMG-WJ open interest=112 current ask $4.00
Picked on September 28 at $ 49.45
Monster - MNST - close: 36.19 change: -0.10 stop: 37.55
There is little change from our previous updates on MNST. We are still waiting for a breakdown under support near $35.00. The pattern remains bearish with a trend of lower highs. Short-term technical indicators are suggesting the next move will be down. Plus, the P&F chart is bearish with a $28 target. We are suggesting a trigger to buy puts at $34.65, which is under the June 2006 low. If triggered our target is the $30.50-30.00 range. If you study the weekly chart you'll notice a long-term trendline of support stretching out just above the $30 level. More conservative traders might want to exit earlier near $31.00. We do not want to hold over the late October earnings report.
BUY PUT NOV 40.00 BSQ-WH open interest=666 current ask $4.80
Picked on September xx at $ xx.xx <-- see TRIGGER
Maxim Integrated - MXIM - close: 28.08 chg: -0.66 stop: 30.05
Bears regained control on Friday. Both MXIM and the SOX index failed to build on their Thursday gains. The failed rally in MXIM under $29 and its 50-dma could be used as a new entry point to buy puts. However, traders may want to wait for the SOX to breakdown from its rising channel before opening new put plays in the industry. There was some chatter on Friday about MXIM getting a delisting letter from the NASDAQ exchange but investors have been shrugging this type of news since a number of companies have delayed their SEC filings, especially now with the ongoing executive options drama. We would keep an eye on the SOX for a drop under 450 or maybe last week's low near 446. Our target for MXIM is the $24.00 level.
Picked on September 25 at $ 27.90
FreightCar Amer. - RAIL - close: 53.00 chg: -0.01 stop: 56.32
RAIL tried to climb higher most of the day on Friday but then suddenly collapsed late in the day. Overall the pattern continues to look bearish. The stock failed to participate in the market's rally and broke down on Thursday. We would still consider new positions at this time. Right now we're suggesting two targets because RAIL appears to have some support near $50.00. We suggest selling half or more of your position at our first target in the $50.25-50.00 range. Sell the rest at our second target in the $46.00-45.00 range. The P&F chart points to a $42 target.
BUY PUT NOV 55.00 RQN-WK open interest= 9 current ask $4.10
Picked on September 21 at $ 54.50
SanDisk - SNDK - close: 53.54 chg: 0.49 stop: 56.06 *new*
SNDK produced a bit of an oversold bounce on Friday but the rebound stalled at the $54.00 level. Overall the pattern continues to look bearish with the breakdowns and failed rallies over the past couple of weeks. We recently adjusted our target toward the $52 level (52.00-51.00) due to potential support at its rising 50-dma. With SNDK relatively close to our target we're not suggesting new plays at this time. More aggressive traders may want to aim lower since the P&F chart points to a $45 target. Be advised that the $50 level has proven to be support in the past. We are adjusting our stop loss to $56.06 since the $56.00 level appears to be short-term resistance. Don't forget that earnings are due out around Oct. 19th.
Picked on September 22 at $ 56.69
U.S.Steel - X - close: 57.68 chg: 0.58 stop: 60.05
It has been an interesting couple of weeks for shares of X and the rest of the steel sector. X and a good portion of the steel industry were trending lower, breaking down under support, and producing new sell signals several days ago. The move was partially fueled by some downgrades and bearish analyst comments about rising inventories. Yet this weakness reversed after RS raised their earnings guidance. Later the same day RS raised guidance another company in the group (WOR) reported earnings, missed the estimates, and issued cautious (bearish) comments about future profits. This helped drain some of the buying interest in the group as did the media's follow up attention on the rising inventory story. Currently we are cautiously bearish on X. Shares have moved from sell signal to bullish reversal to failed rally in the last several days. The larger pattern is still bearish with a steady trend of lower highs and technical resistance at the 50-dma overhead. Aggressive traders may want to consider new positions here. We would prefer to wait for a new decline under $56.00 before opening new plays. Cautious traders may want to tighten their stop loss a point or two. Our target is the $50.25-50.00 range.
Picked on September 22 at $ 55.95
Nucor - NUE - close: 49.49 change: -0.09 stop: 50.01
We have been stopped out of NUE at $50.01. The stock has been trading, and failing, under resistance at the $50 level for over a week but Friday morning saw shares spike to $50.44 before reversing course lower again. The move looks like another failed rally in its long-pattern of failed rallies dating back to May 2006. After reviewing the chart one could argue that our stop loss may have been a little too tight. We would keep an eye on this stock for future play possibilities. Another decline under $48 or $46 could be used to buy puts while a move over $52.00-52.50 could be used to buy calls.
Picked on September 25 at $ 45.95
Options traders buy puts and calls, and market pundits pay close attention to how many of each they buy. Savvy traders do, too.
The CBOE and the ISEE are two of the exchanges that produce ratios comparing the numbers of puts and calls purchased, all for the benefit of those savvy traders. One exchange produces an indicator that breaches a low threshold level when markets are topping: the other, an indicator that breaches a high threshold level when markets are topping. Savvy traders need to know which is which.
The CBOE offers several versions of its closely watched put/call ratios. Equity, index and total exchange versions, including historical data, can be found at www.cboe.com/data/PutCallRatio.aspx/. The names of the several versions are self-explanatory, but each divides any day's put volume on equity, index or total exchange by its call volume. As the volume of puts traded increases in relationship to the volume of calls traded, the ratio rises.
Many savvy traders view the CBOE's several versions as contrarian indicators. If markets have been declining and the ratio being watched rises above a certain threshold level, those traders believe that sentiment has grown too bearish. They theorize that the ratio has given a potential reversal signal. Conversely, if the markets have been rising and the ratio drops below a certain threshold level, savvy traders believe that the low put/call ratio signals excessive bullishness and a potential downside reversal in the making.
These reversal signals tend to be early, many have noticed, so they serve more as a warning that a reversal might be imminent than as a buy or sell signal. Many market pundits warn to combine this sentiment indicator with price-based indicators for confirmation. I would add my caution to use a put/call signal as a warning to get your trading plan in order, but then let price action dictate when or whether you act on that signal.
So how does this whole contrarian thing work, anyway? To understand, think about the two groups of traders: retail traders such as you and me and portfolio managers. The two groups tend to employ options differently. Many retail traders buy calls or puts to participate in an anticipated move. They're buying those options in lieu of buying stocks or futures because of the leverage options provide. Portfolio managers may be buying options to hedge a position. It makes a difference.
Many savvy traders who watch the CBOE's put/call ratios believe that retail traders, excusing themselves from this charge of course, are clueless. They chase moves. The more a market drops, the more puts retail options traders are buying, until they're buying the most puts and driving the put/call ratio above threshold levels just when the selling is about done and markets are ready to reverse. They're buying the most calls and driving the put/call ratio below threshold levels when markets are topping out. This is a simplistic explanation, of course, but it explains the thinking behind the choice of a put/call ratio as a contrarian sentiment indicator.
That's not the only rationale that might be behind the contrarian nature of the put/call ratio. Some researchers, including Bob Pelletier in "The Importance of Put/Call Ratios," believe that it's the portfolio managers, hedging new long portfolio positions with puts or hedging new short portfolio positions with calls, who are responsible for pushing put/call ratios beyond threshold levels as a reversal nears. These portfolio managers are then driving the put/call ratio higher as they're adding new long positions when they believe markets are bottoming and driving it lower as they're entering new short positions as they believe markets are topping. They're given more credit than the retail trader by some market pundits and by some of the savvier traders.
A savvy trader will then pick and choose among the various versions of the put/call ratios, depending on which theory that savvy trader endorses. The savvy trader who believes that it's the delusions of the retail options trader that are most important to watch will likely want to exclude the actions of the portfolio managers. That savvy trader will want to look at the CBOE's equity-only put/call ratio, because the portfolio managers tend to employ index-related options rather than equity options. Portfolio managers are, after all, hedging a whole portfolio and not a specific stock.
The savvy trader who wants to focus on the actions of the portfolio managers will choose one of the other two versions. This savvy trader who might study the OEX or index only put/call ratios, also available on the CBOE's website.
If you read a number of articles or talk to a number of traders, you'll get different answers as to which of the versions on the CBOE website is best to watch, so decide on your focus and then get to know that particular index's permutations. How does it tend to act? What are its particular threshold levels beyond which it's signaling a potential reversal?
To some extent, the threshold levels depend not only on the particular version of the put/call ratio a trader studies, but also the historical values for those ratios, particularly over the last 12-month period, and the current market climate. That wasn't always true. Although the put/call ratios and their four-week averages tended to stay within certain thresholds for twenty years, John Summa notes when writing for Investopedia.com that they've developed a tendency to drift with price action. Summa suggests using that four-week moving average to smooth the ratio. For example, on the chart below, the four-week moving average is encased in a channel that shows its slight upward drift over the last couple of years.
Annotated Daily Chart of the CBOE's Total Put/Call Ratio:
A few points might be made from the chart. First, I haven't chosen a traditional historical band to mark as horizontal upper and lower thresholds, but rather have chosen levels that also roughly correspond to the four-week moving average's touches of or violation of its rising channel. You may or may not agree with this technique, but combining the two seems to work as well for me as other techniques, especially for an indicator that proves helpful but not exact in its timing.
You might want to explore the ideas of other market watchers, with some of them more experienced at watching this ratio. Summa suggests horizontal thresholds surrounding a smoothed four-week average, with the horizontal lines at 0.45 and 0.70. If using the equity-only daily put/call ratio, Summa suggests using thresholds of 0.55 and 0.70 for a smoothed four-week average. Another writer suggests using 1.00 as a single benchmark, with a put/call ratio above 1.00 showing that markets are likely to rise and a number less than 1.00 showing that they're likely to decline.
As should be obvious, any number of writers will have any number of theories about those thresholds, and Summa's notation of a tendency of the smoothing average to drift appears to be correct. Savvy traders will read all these suggestions and find the one that works for them after some experimentation.
As noted earlier and now evidenced by the chart, this indicator is sometimes early. That tendency did show up on the chart, although the tendency was somewhat ameliorated if signals from both the four-week moving average and the ratio itself are required. Note, however, that the extreme thrust lower this spring was still very early, even though it had been preceded by the average's touch of its own support level. This backs up the caution to use the various permutations of this ratio as a warning to prepare a trading plan, but not to assume it will be needed any time soon.
Although traders might disagree about the threshold levels or the version of the put/call ratio to use, they do tend to agree that the signal is a contrarian signal. The ISEE's version is a contrarian indicator, too, but with some major differences. To calculate its version, the ISEE divides the call purchases (not volume, like the CBOE) by the put purchases and multiples by 100. Because calls are divided by puts, rather than puts by calls as in the CBOE's versions, this results in a sentiment indicator that is high when markets might be topping and low when markets might be bottoming.
Look for current values, charts, and some moving averages for this indicator at www.iseoptions.com/. Answering a question in STOCKS & COMMODITIES, writer Tom Gentile suggests threshold levels of 200 and above for possible topping-out action and 125 or less for possible bottoming action.
The information on the ISEE site clarifies that transactions from firms and market makers are not included in this sentiment indicator. Those who adhere to the theory that it's the poor deluded retail trader whose creates the extremes in a sentiment indicator of this type might prefer to study the ISEE's version to see if it provides helpful alerts to extreme bullishness or bearishness. They might begin with a study of Gentile's benchmark levels, but charts on the site show that the indicator has been drifting downward all this year. It's spent quite a bit of time this year at the 100 mark, below that suggested 125 benchmark. Its value on September 28, for example, was 101. For the previous 60 days, the ISEE had placed automatic benchmarks at 159.33 and 105.67.
These charts might not return exact levels to watch, with those thresholds subject to interpretation and showing a tendency to drift over recent years, but they're still helpful to savvy traders. For those who believe in the value of contrarian indicators, they can provide a heads-up that it's time to be thinking about a new trading plan, to be put into effect when price action confirms the reversal. Savvy traders can pick one to study and get to know its peculiarities.
Today's Newsletter Notes: Market Wrap by Jim Brown, Trader's Corner by Linda Piazza, and all other plays and content by the Option Investor staff.
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