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SENTIMENT JOURNAL: Hedged Bets
By Frederic Ruffy, Optionetics.com
9/23/2005 2:00 PM EST

http://optionetics.com/articles/article_full.asp?idNo=13302

Market Internals: Stocks lost ground during the first three trading sessions this week before posting a modest rebound Thursday and Friday. The Dow Jones Industrial Average ($INDU) had suffered a 260-point weekly decline by Wednesday afternoon. However, a 44-point gain Thursday and a 20-point advance midday Friday helped the Dow recover approximately 25% of that loss.

Yet, despite the rebound late in the week, market internals on the New York Stock Exchange [NYSE] remain poor, with advancing issues trailing issues during this weeks first four trading sessions. Midday Friday, advancers were leading decliners by a slim 9-to-7 margin. Meanwhile, down volume swelled and rose above 1 billions shares during this week’s first three trading sessions. The NYSE New High New Low Index [NHNL] also took a turn for the worse. It has now fallen from +251 two weeks ago to negative 37 midday Friday (with 52 stocks setting new 52-week highs and 89 falling to new 52-week lows).

The Nasdaq Composite Index ($COMPQ) suffered sizeable losses during the week’s first three trading days as well. It managed only a modest rebound 4-point bounce on Thursday. Midday Friday, the Nasdaq was off 43 points, or 2% for the week. Market internals on the Nasdaq Stock Market remain lackluster, with advancers trailing decliners during seven of the past nine trading sessions. Friday, Nasdaq advancers were leading decliners approximately 3-to-2. However, the Nasdaq NHNL remained in the red (with 44 stocks setting new 52-week highs and 54 falling to new 52-week lows.)

Sentiment Data: The recent deterioration in market internals (and uncertainties related to Hurricane Rita) caused levels of market anxiety to notch sharply higher during the latest week of trading. Nowhere was this more obvious than in the index market. In fact, the CBOE Index Put-to-Call ratio rose to record highs Thursday as investors scrambled to protect portfolios ahead of the weekend. Index options are contracts linked to the performance of the major averages such as the Dow, S&P 500 ($SPX), and Nasdaq 100 QQQ (QQQQ). Investors often buy index puts when looking to protect portfolios from a decline in the stock market.

The Chicago Board Options Exchange [CBOE] is the largest market for index options. In addition, the exchange posts trading volume information throughout the day and at the end of each trading day. The index put-to-call ratio is included in those daily updates. The ratio is easy enough to compute by hand. It is simply computed as the day’s index put volume divided by index call volume. (Note: Since January 26, 2005, trading volume in the Nasdaq QQQQ exchange-traded fund has been included in the index put-to-call ratio. Prior to this year, QQQQ volume was included in the equity put-to-call ratio.)

When the index put-to-call ratio increases in value, put volume is on the rise relative to calls. The jump in index put volume is generally associated with hedging or bearish activity on the part of investors. In other words, investors are becoming more defensive and index put volume is heating up. On Thursday, total index put volume on the CBOE surged to 1.08 million contracts and one of the highest volume days on record, which is impressive given that it was a non-expiration week. Figure 1 shows the spike in index put volume yesterday.


Figure 1: Total CBOE Index Volume (July 2003 – September 2005)

While index put volume jumped higher yesterday, index call volume totaled less than 300,000 contracts. It was not abnormally high. As a result, the CBOE Index put-to-call ratio finished the day reading 3.89, which is also an all-time high for the indicator. Figure 2 shows the spike in the CBOE index put-to-call ratio on Thursday. In sum, looking at the activity in the index market indicates that bearish sentiment had become extreme on Thursday, which, from a contrarian view, helps explain the midday turnaround Thursday and the market strength Friday afternoon. Investors had become too pessimistic in the short-term.


Figure 2: CBOE Index Put-to-Call Ratio

Yet, while the index put-to-call ratio spiked higher to hint at oversold market conditions on Thursday, other indicators are not consistent with market basing levels of bearish sentiment. For one, the CBOE Volatility Index ($VIX) failed to move past this month’s highs. The market’s “fear gauge” edged lower during the past two trading sessions and is now reading 12.75, which is neutral. At the same time, the surveys of investor sentiment haven’t yet shifted to a bearish extreme. Investors Intelligence reports that 54.3% of those surveyed are bullish, compared to 53.2% bullish the week before. Bearish sentiment fell from 26.6% to 25.5%.

So, while the market appears to be losing momentum, sentiment has not shifted to a bearish extreme that might be consistent with a genuine market bottom. Instead, it appears that the market could easily lose more ground from here because the technical action remains weak while investor sentiment is shifting from a period of high bullishness to a period of rising anxiety or bearishness. This does not necessarily mean that stocks can’t bounce higher next week as investors assess the true economic impact of Hurricane Katrina. It is simply to say that the risk rewards of trading the market to the upside do not seem as favorable as placing trades to the downside.