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Sentiment Journal: Two-Week Rally Hits the Skids
Frederic Ruffy, Optionetics.com
December 14, 2007

http://optionetics.com/market/articles/18674

Market Internals: Stocks traded mixed in a week of relatively uninspired market action. Tuesday saw the most volatility, a day when the Dow Jones Industrial Average ($INDU) gave up nearly 300 points and down volume on the New York Stock Exchange [NYSE] surged to 1.44 billion shares, compared to only 100 million shares of up volume. Outside of that, it was mostly business as usual. Through midday Friday the Dow was up during three of five trading sessions, but due to the big loss on Tuesday, was down roughly 200 points for the week. The technical action was lackluster, with advancers beating decliners only twice and the NYSE New High New Low Index [NHNL] falling back into the red. It fell from +90 a week ago to -132 late Thursday (with 164 stocks falling to new 52-week lows and 32 rising to new 52-week highs.)

The technical action on the NASDAQ Stock Market didn’t provide much excitement either. The Composite Index ($COMPQ) rose only twice (through midday Friday) and, thanks to a hefty 67-ponit loss on Tuesday, was down more than 50 points on the week. Market breadth was poor, with advancers trailing decliners during three of five trading sessions. The NASDAQ NHNL slipped deeper into negative territory, from -21 last Friday to -122 late Thursday (with 26 stocks moving to new 52-week highs and 148 setting new 52-week lows.)

Sentiment Indicators: After two weeks of positive market action and signs that investor confidence was improving, the tone of the market changed again this week. The shift in sentiment was obvious in the options market. For example, on Tuesday, more than 7.25 million put options traded across the six options exchanges, the most so far this month. Call volume equaled 7.216 million contracts and, consequently, the total put-to-call ratio rose above 1.00 for the first time since late November. The action continued later in the week. On Thursday, the ratio rose to a three-week high of 1.04.



A rise in the volatility indexes confirms that risk aversion is back on the rise. The CBOE Volatility Index ($VIX) edged up from 20.85 last week to 22.60 midday Friday. The NASDAQ Volatility Index ($VXN) rose from 23.75 to 25.25. The fact that the volatility indexes were rising along with the put to call ratio indicates that, while investors were actively buying puts for protection, they were also willing to pay slightly higher premiums and, for that, VIX and VXN were on the rise. [While VIX tracks the volatility conveyed by S&P 500 Index ($SPX) options, VXN tracks the volatility priced into NASDAQ 100 Index ($NDX) options.] Typically, when risk aversion is on the rise, it will be difficult for the stock market to gain much ground. It reflects a lack of confidence that will keep buyers at bay and the market bears in control.

Yet, while investors stepped up their defensive activity in the latest week of trading, most of that increase in market angst appears related to the big market drop on Tuesday. Outside of that, trading was relatively orderly, with the Dow seeing average daily moves of roughly 70 points. In addition, that pattern should hold into the final two weeks of the year—a historically quiet period for the financial markets.

In fact, there are a few reasons to expect the market to perform much better during the rest of the year and into 2008. For example, Tom Gentile, our Chief Options Strategist, points out that the last two years of an election term have been positive for the stock market since 1944. According to his Presidential Cycle, the fifteen months before the end of the second term is the best time to be bullish on the market. In this cycle, the timeframe spans from October 31, 2007 to December 31, 2008. Mr. Gentile also researched shorter cycles going back to 1967 and found that bullish and bearish cycles tend to persist for a period of 40 weeks, with the most recent bullish cycle beginning on December 7, 2007. Finally, the stock market might also get a lift early next year from a seasonal pattern known as the “January Effect.” This anomaly is the result of tax loss selling that occurs in December and the “Wash Sale” rule. Basically, stocks that are sold in order to book tax losses in December are often bought back in January. The net result is a historically strong period for the equity market during the first month of each year.