I haven't bought any index puts for a while but the time approacheth as the hangperson draws nearer & dearer to thee..................b warned
The Rude Awakening
Wall Street, New York
Friday, January 28, 2005
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The Rude Awakening PRESENTS: Dumb money is like a Financial Hydra. Although it has many heads, all belong to the same dumb organism - a creature with an uncanny knack for buying or selling stocks at precisely the wrong time. Here's how to slay it...
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THE DUMB MONIES By Eric J. Fry
In a perfect world, "dumb money" might not exist. But the world is not perfect. This little orb we call home has a few glaring defects – like mosquitoes and freezing rain and the New York Times.
But rather than complain about life's adversities, your editors here at the Rude Awakening always try to find ways to make lemons into lemonade, or, if you prefer, cactus into tequila.
Dumb money is here to stay, whether we like it or not. So we might as well figure out ways to turn this negative into a positive. Fortunately, the task is relatively simple: If the dumb money is buying, sell. In general, it is best to "fade" the dumb money's activities – in other words to move gradually against whatever they are doing.
In recent weeks, the dumb money has been loading up on stocks – a worrisome trend in and of itself. What's somewhat more worrisome is that the dumb money remains bullish and confident, even though share prices are falling.
"Dumb money" takes many forms, but its underlying nature rarely changes. It never becomes "smart money," for example, though it make masquerade as such for a while.
Dumb money is a financial hydra – one head may be that of an odd-lot options trader, another might be an AAII survey respondent, another a "small speculator" in the commitment of traders report, and another might even be a commentator on CNBC.
Each head of the Hydra is different of course, but all are part of the same dumb organism - a creature with an uncanny knack for buying or selling stocks at precisely the wrong time. Monitoring the activities of the dumb money, therefore, can sometimes offer helpful clues about the direction of financial markets.
So let's take a moment to have a face-to-face-to-face-to- face with this Hydra and try to gauge where the stock market may be going next.
First up, options buyers on the Nasdaq 100 Index remain remarkably bullish, despite the index's nearly 10% drop from its January 3rd high. Like every other type of dumb- money crowd, this one tends to become most bullish as stocks are topping out, and most bearish as stocks are bottoming out.
"If a good, healthy advance were under way," options pro Jay Shartsis noted yesterday, "we would be seeing much more put-buying. This recent sell-off has been truly remarkable from the standpoint that so few investors are buying puts. There is simply no fear in the marketplace.
"At the market peak last January, the dollar-weighted Nasdaq 100 Trust (QQQQ) put/call ratio got down to about 55 cents in puts traded for every $1 in calls. This signified a high level of option trader optimism, and then the market fell broadly into March 2004. At that bottom, the ratio got all the way up to $1.55 traded in puts for every $1 in calls (high level of pessimism), and stocks turned up again.
"By the end of last month," the savvy options trader noted, "this ratio has dropped all the way down to about 53 cents in puts traded for every $1 in calls. This, again, was a very high level of option trader optimism, and we are now back in sinking mode. At last report, this ratio is at about $1 in puts trading for every $1 in calls, and it's rising. I suspect we will see at least $1.50 - and readings above $2 wouldn't surprise me either - on this indicator again when stocks are ready to rally."
"Okay, you've got me sufficiently worried," your editor replied.
"Wait! There's more!" Shartsis continued, "The VXN Index [measuring options volatility on the Nasdaq 100 Index] has moved up surprisingly little from its nine-year low near 16, with today's close at 18 and a half. Where's the fear? How about a couple of days of serious put-buying? This thing should have spiked up to 25 or 26 by now if the sell off were close to exhausting itself."
The "odd-lot" options traders - known to be among the dumbest of the dumb money cohorts - are similarly bullish. "The odd-lotters [i.e. option buyers trading less than 10 contracts] are fearless," said Shartsis. "They are still in bullish mode as the ratio of puts to calls for those little guys is just .44 (that's 44 puts traded for every 100 calls) - not at all far from the .33 extreme reached in late December as prices peaked. At the March 2003 stock market bottom, this ratio was at about .98 (that's 98 puts traded for every 100 calls). That's a long way from here. The S&P 500 got to just under the 1175 level Wednesday - the bottom of the prior trading range - and that's probably as much upside as it can manage now..."
Small futures traders are also brimming with confidence, which is almost never a good sign. As the nearby chart illustrates, the "small speculators," as they are called, have amassed their largest net-long position in S&P 500 futures contracts since the market peaks of March and June 2004. (The careful reader may also note that small speculators moved to their smallest long position of 2004 during the week of November 2nd, just as the stock market lurched toward its best rally of the year.)
Not surprisingly, the commercial traders – the "Commercials" – are taking the other side of this trade. The Commercials, often called the "smart money," have amassed a rather substantial net-short position in S&P 500 futures contracts. They have placed their biggest bet against the stock market in recent memory.
"The stock market is setting up for a significant decline beginning early this year and continuing into 2006," Comstock Partners warns. "Early 2000 marked the end of an 18-year secular bull market similar to those from 1921-to- 1929 and 1949-to-1966. Each of these periods was followed by multi-year secular bear markets. The peaks of the bull markets were featured by high valuations, excessive speculation, investor euphoria, and a belief that markets had reached a permanent new level of high valuations (a new era).
"In our view current conditions resemble those of past tops," Comstock continues. "The S&P 500 is selling at 21 times trailing reported earnings with a skimpy dividend yield of 1.8%. Investor sentiment is frothy while equity mutual funds maintain historically low levels of cash as a percent of assets. At the same time the Fed has now raised rates at each of last five meetings with a sixth one likely soon...The federal fiscal policy that created a strong tail-wind for the market over last two years is now in the process of reversing and becoming a head-wind instead.
"The market has gotten off to a poor start in January," Comstock concludes, "indicating a potential end to the counter-cyclical bull market of the past two years as the new money flows so widely expected have so far failed to materialize...Although the recent drop has brought the market into temporarily oversold territory and a test of the recent highs is still possible, we think that the risks have increased substantially and that stocks are highly vulnerable to a sudden downdraft."
