Market Internals: Stocks rose during two of this week’s four trading sessions, but lost ground on the week due to big losses on Wednesday and Friday. The Dow Jones Industrial Average ($INDU) suffered a four-day 240-point loss. The NASDAQ ($COMPQ), which had risen in five of six trading sessions prior to Friday, lost nearly 50 points on Friday. For the week, the NASDAQ gave up roughly 30 points.

Market volatility remains high. The Dow has experienced triple digit moves during four of the past seven trading sessions. Two of those moves exceeded 240 points. In addition, the market breadth statistics (see table 1) reflect the underlying levels of market volatility that continue to cause big moves in the major averages. For example, on Friday (first column), the Dow lost 249 points and decliners beat advancers by a ratio of 4-to-1. However, last Wednesday (last column), the Dow rose 247 points and advancers trounced decliners by a margin of six-to-one.  So, while it’s easy to get caught up in the emotion of each day’s moves higher or lower, it is important to note that the volatility is not only happening on the down days. It happens on the up days as well.   

Sentiment Indicators: After a brief return to normalcy during the second half of August, bearish sentiment is once again on the rise in early September. The CBOE Volatility Index ($VIX), which fell from a high of 37.5 to a low of 20.5 during the third week for September, is back up above 26. The market’s “fear gauge” closed up 2.24 to 26.23 on Friday. The NASDAQ Volatility Index ($VXN), which fell from a high of 34.75 in mid-August to a low of 20.69 in late August, is back near 30. VXN rose 2.58 to 29.22 on Friday. The recent rebound in both volatility indexes is a sign that this week’s market decline has renewed some of the market fear, angst, and pessimism that surfaced and reached an extreme in mid-August.  

Signs of bearishness surfaced elsewhere in the options market.  Traders are once again favoring put over call options and the CBOE put-to-call ratio is rising. This indicator measures the day’s put volume against call volume for trading on the Chicago Board Options Exchange [CBOE]. When it rises, the ratio indicates that investors are more actively trading puts relative to calls, which is generally a sign of more defensive or protective positioning. Prior to Friday’s trading session, the CBOE put-to-call ratio (10-day average) was near 1.06. While that is well below the recent highs of 1.25 set in mid-August, it is high relative to its historical range. Figure 1 shows the action of the ratio in recent years. It hit an all-time high in March 2007 and rose back up towards those levels in mid-August. It fell from mid to late August, but is moving higher once again.  

Figure 1: CBOE Put-to-Call Ratio (10-day average).

Other, longer-term, indicators are also consistent with a market that is still dominated by the bears. For example, according to the American Association of Individual Investors [AAII], bears outnumber the bulls. In its latest survey, bullish sentiment fell to 38.38% from 40.30%. Bearishness declined to 42.42% from 46.27%. Meanwhile, Investors Intelligence says that its latest survey showed a modest increase in bullishness, from 41.7% to 42.9%. Bearishness remained near 4-year lows of only 37.4%.   

So, as was duly noted in our last report, bearish sentiment remains high and, from a contrary view of the market, this is a positive for the equity markets going forward. It sets up the possibility that the stock market is deep oversold and will begin climbing the “wall of worry.” However, market volatility remains high (see first two paragraphs) and it can be difficult in this environment to turn aggressively bullish—especially during weeks when the major averages are falling and suffer losses. Nevertheless, the sentiment indicators lined up in early August to suggest that bearishness and pessimism reached an extreme—a relatively rare happening that often sets the table for a market bottom. Therefore, now is still a good time to look for some opportunities in quality stocks that have been beaten down. Then, look for longer-term opportunities that won’t break the bank if the carnage continues. The call ratio backspread is one of several strategies that come to mind. 
 

Frederic Ruffy
Senior Writer & Index Strategist
Optionetics.com ~ Your Options Education Site
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