Market Internals: The week started off innocently enough. On Monday, the Dow Jones Industrials ($INDU) rose 8 points. From that point forward, a round of selling ensued and knocked the Dow for a three-day 410-point loop. The tape became progressively worse as time passed (Friday’s numbers not available due to travel.) By Thursday, the panic phase had set-in, as down volume outpaced up volume on the New York Stock Exchange [NYSE] by a modest of margin of 17-to-1! At the same time, advancers trailed decliners more than 10-to-1. The NYSE New High New Low [NHNL] index also took a turn for the worse. It tumbled from an extreme of +416 last Friday, to a –90 late Thursday (with only 27 stocks setting new 52-week highs on the NYSE and 117 sliding to new 52-week lows.)

On the NASDAQ Stock Market, each day got progressively worse as well. The NASDAQ Composite Index ($COMPQ) rose 4 points Monday, fell 7 on Tuesday, lost 24 on Wednesday, and plunged 46 points on Thursday. Up volume trailed down volume two-to-one on Tuesday, three-to-one on Wednesday, and more than 6-to-1 on Thursday. The NASDAQ Advance/Decline ratio told a similar story (see table above). Finally, the NASDAQ NHNL also fell into the red. The ratio sat at +191 last Friday, but fell to –31 on Thursday (with 52 stocks setting new 52-week highs and 83 stocks falling to new lows.)

Sentiment Indicators: At the conclusion of our last installment of Sentiment Journal (SENTIMENT JOURNAL: Midweek Reversal Raises Anxiety Levels, May 25), we noted that “Now, risk perceptions are rising once again. Therefore, from a contrary view of the markets, an explosive situation exists. Namely, risk perceptions and anxiety are beginning to rise after a period of complacency, bullishness, and overbought conditions….So, let’s be careful out there.”

How fast things can change. Although trading was relatively quiet during the final week of May, things quickly took a turn for the worse in the first full week of trading in June. Simply put, the three-day sell-off that started on June 5 triggered a sharp and noticeable spike in risk perceptions. As evidence, CBOE Volatility Index ($VIX) rallied 14.75% Thursday to 17.06 and its highest levels since mid-March.

The jump in the VIX was accompanied by a sharp jump in index put volume. The numbers are impressive. On the day, almost one million put options on the S&P 500 Depositary Receipts (SPY) traded on the Chicago Board Options Exchange [CBOE], which is today’s largest options exchange for index trading. Another 873,690 puts on the iShares Russell 2000 Small Cap Fund (IWM), 686,461 puts on the NASDAQ 100 Index Trust (QQQQ), and 175,762 on the Dow Jones DIAMONDS (DIA).

Figure 1 shows the daily index put volume for trading on the Chicago Board Options Exchange (which also includes ETFs such as the SPY and the QQQQ). The volume on Thursday represents the highest amount of index put activity since the mid-March market bottom. It was the tenth busiest day of index put option activity on record. 

 Figure 1: CBOE Daily Put Volume

The jump in the VIX and the rise in index put volume confirm that three-day sell-off rattled more than a few feathers. A large number of investors became very pessimistic, bearish, and by Thursday, panic-stricken. Now, the question is whether or not they have overreacted in the short-term. Chances are… yes. However, given that the stage was set for a market decline by excessive bullishness, complacency and optimism just a few weeks ago, there could be more damage to come as greater numbers of bulls jump into the bear camp and selling begets more selling.