Market at a Crossroads

The bull thesis right now goes roughly as follows: Investors are over-hedged and underexposed en masse, as evidenced by a recent reading of 1.2 in the 10-day moving average of the ratio of total put-buying to total call-buying on the CBOE options exchange.

It sounds like a complicated idea, but it's quite simple: 1.2 in that measure is a very rare level. We have only seen it happen a handful of times over the past 10 years and each time signaled that we were at or near an important market low. The past three times it reached that level in the past five years are highlighted in the chart below by the green arrows. The fourth time in that span occurred on October 6.  

 

                         Source: Trading View (www.tradingview.com)

Accompanying this measure is another important contrarian signal: hedge fund short exposure according to a measure put out by Sentimentrader.com based off of a composite index of hedge fund tracking indexes. The measure compares the day-to-day changes in this composite index of hedge fund exposure against the day-to-day changes in the S&P 500. The more positively correlated the two data points are, the more net long interest can be inferred to be held among hedge funds, and vice versa.

Typically, when hedge funds are heavily short (i.e., when the composite hedge fund tracking index and the S&P 500 index are moving inversely on a day-to-day basis), the market is generally near or at a key low, especially when this occurs in tandem with a strong skew toward put buying in the put/call ratio described above.

Right now, hedge funds, according to this measure (see chart below), are carrying the most short interest in stocks in over 4 years. This measure has been at or near its current level 8 times in the past 7 years. Only one of those instances was followed by a near-term significant decline (September 2018).  

   

                                                          Source: Sentimentrader.com

At the same time, the market is approaching its seasonally strongest period, which occurs from roughly the final week of October to the close of December according to the Stock Trader's Almanac.

In this mix is the move higher in interest rates on longer-duration treasury bonds. Yields on the US 10-yr T-Note have soared all the way to test the critical 5% level. One can make a case that a capitulation in the upward move in interest rates, if accompanied by demonstrable resilience in the equities market, could signal a key buying opportunity heading into the final 8-10 weeks of the calendar year.

So, that's the bull case right now.

However, the key phrase in all of the above is if accompanied by demonstrable resilience in the equities market. In other words, the market needs to send the right signals in terms of technical posture, breadth, and behavior around key support levels.

What we are so far seeing to close this week is anything but those right signals. In other words, it's a good time to be prepared for a buying opportunity. But that Buy Signal is not in place right now. With several exogenous risk factors in the picture, including escalating war in the middle east, inflation uncertainty, and complete chaos in the US House of Representative, the #1 rule is Risk Management.

The most successful investors generally don't try to catch the exact low in a weak tape. Many ingredients are in place for a coming rally. But bearish trends can feed on themselves and produce even more dramatic extremes in the indicators above. We may, for example, be heading for a lower low in the major indices that produces a 10-day Put/Call average reading of 1.25. Or perhaps this is the second instance of all the hedge funds being right together at the same time in the past 8 years. It pays to remember that market forecasting is a probabilistic enterprise.

In other words, the take-away message here is: stay safe but have your shopping list ready.