ISEE Trouble

An already narrow market has lost its leaders last week. Now this option indicator is flashing a rare but reliable bearish signal. Could a true correction finally be upon us?

Over the past month much ink has been spilled, here and increasingly elsewhere, concerning the narrowness of the market during its latest advance. A few of the stats include the fact that four mega cap stocks, Amazon (AMZN), Apple (AAPL), Facebook (FB), Google (GOOGL), had come to represent a 32% weighting of the Nasdaq. As of July 31st just 10 stocks account for over 42% of the Nasdaq 100’s 7.2% gains to that point.

Indeed, two weeks ago, even as the QQQ went parabolic and hit successive new highs breadth was negative with 3 losers for every 1 winner. Indeed, there were actually more 52-lows hit than new highs. The picture in the S&P 500 and Russell 2000, though not as dramatic, was not much different as nearly half of the stocks that comprise those indices are down by more than 12% and 29% are down 20% or more thus far this year. We have noted is there has been a stealth correction in both time and price underneath the surface.  Only 3 of the 10 S&P 500 sectors have posted gains in 2015.  Healthcare, Tech, and Consumer Discretionary. Some sectors, especially commodity related, have been in full blown bear markets.

Historically Bad Breadth

It all added up to a historically narrow market which was extreme enough for topic to the front pages of not only the Wall Street Journal and Barron’s but also USAToday.

Historically such bad breadth near all-time highs has been unequivocally bearish for stocks over following one week to one week to one month time horizons.

Lyon a.d 7.20.15

But despite lousy internals market investors seemed to embrace the rally at the end of July as an “all clear” clear sign. The VIX dropped 45%, from 20 down to 11.5, in a five day period, its steepest one week drop in over decade. Standard put/call ratios also tumbled to indicating more bullish call activity.

I was starting to wonder if this stealth bear market in which a host of stocks, indeed whole sectors, that are beaten down, oversold and potentially undervalued might actually be a good thing. Meaning could a rotation into these beaten down sectors could provide plenty of fresh ammo for a new and broader move higher even if most of the juice had been squeezed out of handful of high beta meg caps.

The Generals Taken Out and Shot

I got my answer last week. It was a resounding no! Not only did the commodity/industrial and manufacturing complex hit new 52-weeks but there was major damage done to the aforementioned leaders.

This includes a 15% drubbing of Apple. A 12% decline in Disney which spilled over into the rest of the media sector with shares of Fox, Viacom, Discovery and CBS all tumbling more than 10% last Thursday and Friday. Healthcare and biotech, which had been the strongest sector, was not immune to the selling as those sectors slumped 7% and 4.5% respectively.

With the loss of the generals and soldiers still lying wounded on the ground it the technical picture looks bleak for the bulls in coming week.

ISEE Trouble

Adding to the troubling price action last week we got a rare, but reliable red flag warning from one of my favorite option indicators. The ISEE which is actually a call/put ratio. What makes the ISEE unique, and more useful, compared to standard put/call ratios is it uses only long, or new purchases, by customer accounts. In this way it strips out hedging by professionals or market makers, the sell side of spreads, or closing transactions, such as buying to close options that had been previously sold short. I focus on the equity on ratio, which removes trades in indices and ETFs. All of those types of transactions can give an inflated and misleading snapshot of volume.

What we are left with is strictly the true intentions of the investor and money managers. Now typically this would act as a contrary indicator, in that when put buying swamps call buying it would mean pessimism has reached an extreme and we could be approaching a near term low.

But what we have seen of late is something of anomaly; the ISEE equity only ratio closed below 100 four consecutive days last week. This follows two closes below 100 the prior week.

ISEE equity ratio 8.8.15

To understand how rare that is consider since its inception in 2006 the ISEE has recorded 2 straight days below 100 just 8 times. It has three consecutive closes just once. There have never been four consecutive days.

Now comes the even more interesting, and possibly troubling part. In seven of the prior instances such extreme put buying or “fear” have market short term bottoms and were followed by strong gains over the next week to 3 month period.

ISEE Lyons 8.9.15

But what is notably different this time is we are getting readings while the indices are near all-time highs and volatility is low similar to the September 2014 occurrence:

  • At -1.54%, it is the only one besides last September (-1.42%) that occurred less than 2.8% from the S&P 500′s 52-week high.
  • At -0.07%, it is the only one besides last September (-0.97%) that occurred while the S&P 500′s 3-week return was better than -2.35%.
  • At roughly 12-13, it is the only one besides last September (13-14) to occur while the S&P 500 Volatility Index (VIX) was trading at less than an 18-handle. 

Divergence/Convergence

So what we have is a strange divergence of very bearish option activity within a seemingly complacent and low volatility market. Note that during the similar occurrence September 2014 stocks had the nearly 10% into the middle of October.

Again, some of these atypical readings could be a function of the wide divergence between the few leading stocks and all those sitting near 52-week lows. Last week’s takedown of those leaders suggests the convergence or resolution will be to the down side.

Or maybe we now have had a sufficient correction. Time will tell. But as I suggested a few weeks ago having some correction protection probably makes sense.

Forewarned is forearmed.

— Steve Smith

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About the Author: Steve Smith