Sauntering along Sentiment Lane for the S&P500 and equities

Folks, remember you can find this TickerSense sentiment poll every Monday at the TickerSense on typepad site in the "other sites of interest" at the right side of this page. Where you can also find the link to Schaeffer's Research, whose SVP of Research, Todd Salamone, always provides some insightful analysis each Monday morning. Personally, I've seen nothing yet to shake me from my own projections for the market (which I've posted here and at my UBTNB3 site) ... in any case I always like to take Todd's comments into consideration. Here's a quote from his article there this Monday morning:

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Traders and investors added more than 500,000 puts on the S&P Depositary Receipts (SPY) last week. Roughly 1 quarter of the put activity was related to out-of-the-money trading at the February 73, 74, 75, 76, 78, and 80 strikes. A huge majority of the buy-to-open activity occurred at the 73 and 80 strikes, whereas the 74 and 76 strikes were mostly sell-to-open activity. Other put strikes saw a balance between buy-to-open and sell-to-open transactions. An analysis of this put activity indicates that investors are clearly seeking protection on a break of the 800 mark by the SPX, with some investors expecting a significant move below the index's November low in the 750 area. Still others, as is evident by the sell-to-open put activity at the 74 and 76 strikes, are betting that the SPX's November lows will hold by February expiration.

While the SPX bent last week, it didn't exactly break. The index traded below support at the 820 level, but it closed back above this key region by the close of the week. As we have previously discussed, technicians have focused on this area, since it represents a 61.8% retracement of the index's November low and its January high. The lows set last week occurred near the round-number 800 mark, which also happened to be the close at the Nov. 21 low.

Should 820 decisively break, the 750-800 region becomes extremely important, as this is a "breakeven" area for investors who not only bought at the November lows, but also the 2002-2003 lows. On the upside, the first technical resistance area is 850-860, site of the September and October lows and an area of support in December. The next major overhead resistance level would be the 900-century mark, which coincidentally, is now the site of the index's downward-sloping 80-day moving average.
[chart showing this 80 DMA - see Todd's chart in his original article at Schaeffer's]

On a final technical note, I should mention that the Dow Jones Industrial Average once again closed above the important 8,000 millennium mark. Despite numerous moves down to this area or below since October 10, there have been only 3 daily closes below 8,000, one of which was a close of 7,997.

We continue to have concerns for the long-term prognosis of the market, but the next few weeks could represent a mighty struggle between the bulls and bears for the following reasons:

1. The CBOE Market Volatility Index (VIX) continues to trade above its half-high at 44.76. But the VIX has failed to make a convincing move above the 55-56 area, site of its 80-day moving average and a level of support from Nov. 6 through mid-December. For this reason, VIX behavior could be viewed as "neutral."

2. Short-term sentiment, as measured by customer buy-to-open put and call activity on the International Securities Exchange (ISE), is moving out of an extreme optimistic condition. However, readings are not yet near the extreme pessimistic conditions that have marked short-term market lows. The 20-day moving average of the ISE's all-equity call/put ratio currently stands at 145, down from its peak of 160 at the end of 2008, but far above major troughs in 2008. This moving average bottomed at 105 in March, 114 in mid-July, and 108 in late November. The current reading would suggest that we have not yet achieved the pessimistic extremes among the options crowd that have marked short-term market bottoms going back to March.

3. Given the big buy-to-open put activity last week at the SPY 80 strike (equivalent to 800 on the SPX), and the significance that tends to be attached to round numbers, the 80 level on the SPY could become a huge bull-bear battleground in the days and weeks ahead. With some investors protected on moves below this level, panic selling is less apt to occur on a break, and thus this level could become supportive -- for the time being, anyway.

4. We are still early in the expiration cycle, and thus we expect additional headwinds from put buyers seeking portfolio protection.

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Okay! I'm also going to add some quotes from the related article about the buy-to-open put activity, from this morning at Schaeffer's by Rocky White, their Senior Quantitative Analyst - because this is very interesting too (and frankly, does dovetail rather neatly with my market thoughts):
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This week, we are looking at another put/call ratio as a market indicator: the Chicago Board Options Exchange's (CBOE) buy-to-open put/call volume ratio of S&P 500 (SPX) options. ... [see charts in his original article]

For today's purposes, we are focusing on buy-to-open trades. So, if a trader is buying a put option, we know they can be speculating on a downward price move or hedging against a long position in the underlying asset. Excluding other types of trades helps us narrow down the motivation of the volume. Knowing the motivation behind the trades can make a big difference in how you interpret the data.

Interpreting the Data: As contrarians, we try to determine whether the sentiment of the crowd is optimistic or pessimistic. If we find that the sentiment is unwarranted in either direction, then we believe there is an opportunity to make money. An excessive amount of puts usually means the crowd is pessimistic; thus, we look for bullish opportunities. However, this is only the case if the puts are speculative bets that the asset is going to fall in price. We know that most SPX options are not speculative bets on a bearish market move, but rather as a vehicle to hedge. Therefore, an increase in SPX puts usually means that a trader increased the size of his portfolio, and therefore needed to purchase the put options in order to hedge his expanded long position. So, the increased put volume is not bearish speculation, but rather, bullish speculation! You see, it is important to know the motive behind option volume in order to determine the crowd sentiment.

Current Reading: Looking at a graph of the 50-day put/call ratio -- i.e. the number of put options purchased during the past 50 days compared to the number of call options purchased -- we can see that this ratio has moved nearly in tandem with the SPX. After digging into the data, we discovered that the ratio is falling not because of an increase in call buying, but because of a decrease in put buying. As we mentioned before, SPX options are used mainly for hedging big portfolios. As big money players continue to liquidate positions and de-leverage, there is less reason to hedge. As such, we are seeing a decrease in put activity, and therefore a falling put/call ratio.

Implications: The market will continue to fall as long as this mass de-leveraging is taking place. We are keeping a close eye on this ratio, which seems to coincide with the market. If this ratio turns upward, then it might be a sign that the market-wide liquidation is coming to an end. For now, the ratio is falling, and we advise people to be very cautious.