The S&P 500 Index (SPX) locked in another positive week, as it gained roughly 1.2 percent from the previous Friday’s close. What’s more, it was another expiration week that enjoyed gains. As I mentioned in last week’s Monday Morning Outlook, nine out of the past 11 expiration weeks had seen gains. This positive uptrend was most likely helped by the unwinding of hedges against out-of-the-money put positions on the broad-market exchange-traded funds (ETF) such as the S&P Depositary Receipts (SPY).
In fact, it appears that this trend could continue as option trading grows more popular. In reviewing some of the data provided by the Options Industry Council (OIC), it looks like we’re operating in an environment where option open interest is about 50 percent higher than the levels of two years ago. It would seem that the influence of option activity on the stock market has grown substantially.
Furthermore, it is interesting that the put/call open interest ratio is exactly flat from beginning point to end point (this information is updated daily). What seems to be of greatest interest in the put/call data is the bottoming of the ratio in mid-2006 and the rise since then as the market has been rallying sharply. This is the only period encompassed by the attached data in which the market was clearly trending.
Meanwhile, as the OIC put/call open interest ratio has been on the rise during this market rally, indicating a growing preference for puts over calls, many market watchers have been quick to point out the ascent in the percentage of bullish advisors in the Investors Intelligence survey. Last week’s report revealed that the percentage of bullish advisors slipped slightly to 59.6 percent after hitting a high of 59.8 the prior week. The highest level before that was 60.4, which was reached in December 2005. Those polled are displaying healthy optimism in the market and in the economy, thanks to a successful earnings season that has been put to bed, reduced energy prices, and an election turnout that leaves the country under bipartisan rule.
While extremes in optimistic sentiment often mark tops in the broad market, there are a couple things a contrarian needs to keep in mind. The first being that optimism in a bull market is to be expected and, thus, is a far weaker contrarian signal than optimism in a bear market.
One other interesting fact that Joseph Sunderman, head of our Quantitative Analysis Department, pointed out last week, is that pullbacks following highs in bullish sentiment according to the Investors Intelligence survey have been far weaker in a bull market than pullbacks in a bear market.
Another indicator that has sent many market watchers into a froth has been the descent in the CBOE Market Volatility Index (VIX). Last week, the index dipped back below the 10 level and tagged a fresh 14-year low of 9.34. While this is a potential sign of complacency, anecdotal evidence points out that many are interpreting this indicator bearishly.
When the VIX closed two consecutive sessions below the 10 level (on November 20 and 21), the SPX pulled back following the Thanksgiving holiday roughly 1.4 percent before putting in a bottom. However, from that bottom, the broad-market index has rallied nearly three percent during the past three weeks. Not exactly the weakness expected by analysts who have expressed negative views about the VIX in the media. In fact, the steady ascent in the SPX has resulted in a general reduction in volatility, creating a low VIX.
While there are signs of optimism in the market (such as the high Investors Intelligence survey), there is a guarded quality to this optimism, as the financial media is filled with bearish comments and headlines regarding the low VIX and slowing economy. This wary atmosphere is very much unlike the exuberance that filled the air in 2000 just before the bubble burst. Such caution leaves the door open for additional gains as more of the skeptics leave the sidelines.
From a technical perspective, we have a pair of round-number levels drawing interest. The Russell 2000 Index (RUT) continues to struggle with the 800 level. The small-cap index briefly popped above the round-number level on December 5 when it tagged a high of 801.01, but has since moved sideways, hammering against this level. This barrier needs to be taken out soon if the market is going to make much progress by year-end.
Meanwhile, the London FTSE 100 has found support at the 6,000 level. The index pulled back to and bounced off support at both the round-number level and its 80-day moving average at the beginning of the month. The recent rally in the index has carried it near a six-year high.
