An Overabundance of Confidence

When looking at the charts of individual stocks, we find many that “look good”. This is undoubtedly one of the market's main saving graces. The problem with this is of course that charts always “look good” until they suddenly don't anymore. Shortly before the crash of 1987, to name an extreme example, the charts of many stocks, as well as those of the indexes, also looked good. There was very little in the technical backdrop that indicated that things would change radically and go totally pear-shaped in the space of just one week. And yet, this is what happened. The only warning provided by the charts was that the market suddenly and inexplicably became extremely weak in the week prior to the actual crash day.  It put in a lower high on that occasion, which by itself is also not an entirely reliable sign that things are about to go seriously awry.

We are only using this example to illustrate that there is sometimes more to the situation than just the message provided by the charts. Normally, charts will deteriorate slowly enough to provide plenty of warning that the technical underpinnings of the market are weakening – but this is not always the case (it did happen in late 2007/early 2008, but even at that time, the message was for 'mixed' for quite some time. For instance, the DJ transportation average made a new all time high in May of 2008).

Anyway, in order to gauge the market's temperament, or at least the effects of the most widely adopted belief system, we can also look at quantitative sentiment data, and since a few remarkable things have happened on that front lately, we are providing a brief update. As to the “belief system” adopted by most market participants, it is the sheer boundless faith in the machinations of central banks. We happen to think that relying on these bureaucrats is dangerous, regardless of the fact that is has obviously “worked” for a good while now. It is the modern-day variation of the “potent directors fallacy” – the belief that a handful of powerful people can actually stop the market from expressing itself in an untoward manner. There are countless historical examples that show this belief to be erroneous, with the 2008 dislocation being the most recent one.

We regularly look at put-call ratios and the like, and came across a rather remarkable combination of data last week. The equity put-call ratio declined to its lowest one day reading in several years last week, while almost concurrently, there was the biggest spike in the one-day reading of the OEX put-call ratio in at least 20 years (we cannot tell for sure if it was a record high, since we are only able to consult data going back two decades). At the same time, the VIX (which measures volatility premiums paid for SPX at and near the money front month options) has declined to below 11, which is roughly in line with the lowest values seen in 2007:

The equity volume p/c ratio spikes to an extreme low, the OEX p/c ratio spikes to the highest one day reading in at least 20 years – click to enlarge.

Why is this important? There is a rule of thumb that says that OEX options are mainly employed by “smart money” professionals to hedge portfolios when they feel the market is for some reason overstretched, or they have the idea that something will soon disturb the market's tranquility. By contrast, equity options are in the main considered the play-ground of smaller traders, and are therefore held to give contrarian signals. When high OEX and low equity p-c ratios coincide, a strong warning signal is therefore given (mind: the warning is of a correction, it is not indicating anything about its likely severity). In order to eliminate some of the “noise” of the daily signals, the late Decisionpoint service (now merged with stockcharts) always employed a 10 day moving average of these ratios, which is depicted below together with a chart of the SPX. The essential point remains the same however -  it is even underscored by the fact that on a 10-day basis, there have been enormous moves in both ratios as well:

The 10-day ma of the equity p/c ratio vs. the 10 day m/a of the OEX p/c ratio -  rare extremes have been recorded – click to enlarge.

We have also constructed a “ratio of the ratios”, i.e., we have divided the 10 dma of the equity p-c reading by that of the 10 dma of the OEX p-c, which creates an oscillator that is obviously also at one of its lowest readings ever:

The ratio of the ratios collapses accordingly. - click to enlarge.

Bulls, Bears and Pigs?

Next we want to show recent updates of various Rydex ratio permutations. There is for one thing the bull/bear asset ratio published by sentimentrader. The peak readings that have so far been reached twice this year, slightly exceeded the peak readings of early 2000. Thus, although the “man in the street” remains more wary of the stock market than he was in 2000, professional traders are more excited than ever about the bullish possibilities (alas, they were completely unexcited at the 2009 lows when they should have been excited):

Rydex bull/bear asset ratios: exceeding the extremes of early 2000 - click to enlarge.

The picture is similar when looking at the ratio of all Rydex bull funds and bullishly positioned sector funds vs. bear assets. The main culprit in catapulting the ratio to such unprecedented levels has been the utter capitulation of both bears and fence-sitters:

Rydex bear fund assets (red line), and Rydex (bull + sector fund assets)/bear fund assets – here too we find two readings in 2014 that have exceeded the year 2000 readings, mainly because the capitulation of the bears has been even more pronounced this time around.

We keep hearing that people “hate” the stock market, except that they obviously don't. In fact, even “mom and pop” are finally back in the market, as several recent press reports indicate. After its incessant rise from the lows in 2009, the market is apparently finally deemed to be “safe”! The “fence sitters”, whose commitment we can roughly measure by looking at the amount of money in Rydex money market funds, have lowered their cash reserves to levels last seen in the late 1990s. Note that adjusted for the explosive growth in money supply (up approximately 250% since 1999 in terms of money TMS-2) or even adjusted for CPI, this amount is a lot smaller in real terms than it appears in nominal terms:

A collapse in nominal terms, and an even bigger collapse in real terms: money in Rydex money market funds – click to enlarge.

Speaking of cash reserves, here is a recent update of the cash-to-assets ratio of mutual funds. At its current level of 3.6%, it is just 20 basis points above its all time low – and since 2010 this percentage has been persistently at or near the lowest levels in the history of the data:

The lowest mutual fund cash reserves relative to assets in history – click to enlarge.

Obviously, this is not an indicator of near term significance. All it is telling us is that when the eventual denouement comes, it is likely to be very painful, because these funds cannot “take advantage” of falling prices. On the contrary, if they are faced with redemptions, they will be forced to sell and thereby contribute to the eventual downturn.

Meanwhile, the ratio of bulls to bears in the Investor's Intelligence survey of market newsletter writers, which has recently hit the highest level since the summer of 1987, is once again trending up to an extreme level, but is at present slightly diverging from market prices:

The II poll – the bull-bear ratio is back near recent extremes, but is slightly diverging from the SPX, which has moved to a higher high concurrently – click to enlarge.

Euro and Yen vs. Dollar

Finally, we have noticed that bearish sentiment on the euro remains very high. As an example, here is a recent sell-side report that stubbornly clings to the consensus on treasury bonds, the euro and gold. Although these calls have been wrong for quite some time, analysts are evidently still sticking with them. This is a sign that things are likely to continue to play out differently than expected until someone cries 'uncle'.

For instance, speculator positioning in the euro is already at a bearish extreme relative to recent history – it was only even more extreme back in 2012, when everybody thought the euro would soon cease to exist:

Speculators are already positioned for a big decline in the euro. This opens the possibility for a big move in the opposite direction if their expectations prove wrong – click to enlarge.

Bearish speculative positioning in the yen is also somewhat less pronounced at the moment  than it was at its most extreme a little while ago, but it remains very high historically. The level of net speculative positioning is roughly comparable to that seen at the major yen lows in 2006/2007:

Speculative positioning in the yen remains extremely skewed as well – click to enlarge.

The yen is of course liable to rise in the event that the stock market should decline, so this is a data point one should definitely keep an eye on.

Conclusion:

Even though many individual charts look just fine (keeping aside for the moment that there are also many strong 'overbought' readings in a number of sectors), enthusiasm by market participants has in some respects become even more extreme than it was earlier this year. It is quite interesting that people were darkly bearish at the best buying opportunity in about 20 years (the daily sentiment index indicated that there were a mere 3% bulls at the 2009 low), but are now infused with never before seen optimism after the market has roughly tripled from these levels.

In addition to this overabundance of confidence – which we ascribe to an irrational and not very well-founded faith in the omnipotence of the “potent directors” running central banks – we now have a few important warning signals popping up. Per experience, the longer the market ignores such warning signals, the worse the eventual denouement will turn out to be.

Charts by: Stockcharts, Sentimentrader