Below is an excerpt from a study that originally appeared at Treasure Chests for the benefit of subscribers on Monday, August 7th, 2006.

In an attempt to further define the larger process concerning this subject matter now, we would like to take you on a journey into the internal workings of the US stock market from a sentiment perspective, where it should be understood that as an end result, how hedgers and speculators bet in the derivatives market(s) largely effects general price direction as participants react to the manifestations of their wagers set against the totality of influences. More specifically, and in realizing how market participants are betting essentially constitutes the ultimate measure of sentiment towards future prospects for respective markets, here it's important to realize contrarian thinking plays a big role in terms of how the intelligent observer (that's you) should shape his or her views. That is to say, if a majority of participants are betting on a bearish outcome in a particular market, chances are the opposite will occur as gamblers are forced to alter their views as process unfolds.

Here, primary components of the process involve administrators not only knowing the rules of the game, where we will liken them to being the 'house' in a casino; what's more, they actually write the rules, where brokers write put options the hedgers / speculators acquire in betting on an outcome in a particular market. And of course because the reality of current economic circumstances would have a reasonable man betting against a positive outcome for equities, where a majority of participants naturally have a penchant for betting in this fashion because it's logical, add into the equation efforts on the part(s) of central bankers and politicos to thwart economic irregularities, where opportunistic money supply creation and government spending work to counter natural market forces, and you then have a formula for what is termed a 'short squeeze', where market participants are systematically forced out of what turn out to be 'bad bets' set against a backdrop of what appears to be never ending liquidity.

It should be understood then it's this dynamic that formulates the basis of market forces most heavily influencing general price direction, where the ratios of bullish bets (calls) set against bearish bets (puts) create factors that can be utilized is ascribing outcome probabilities in the various stock markets we follow, allowing us to not only avoid potentially nasty spills when sentiment appears euphoric, but also capitalizing on shorting opportunities as well. And while such endeavors might possibly involve hedging activities associated with profitable long positions, naked shorting (not owning a long position in a security / market you are short) is an activity that can be quite profitable for the real risk takers also, where if approached in a systematic fashion, one aimed at removing as much risk out the formula as possible, successful outcomes are not the impossibility most experience. Here, our experience has taught us not only is it necessary for one to have market direction right, but because of the mature nature of the current environment, one where the establishment works to thwart natural corrections in process out of increasing necessity to their own survival, a successful speculator must be equally concerned with execution and instrumentation, meaning attempting not to put positions on too early, and when you do, make sure one buys enough time to allow for delays known to be a likelihood due to interventions.

Moving into practice now that we have a theoretical foundation for this study established, from a practical perspective at this juncture it makes a great deal sense to take an in depth look at the world of put / call ratios on US stock market indices we follow because not surprisingly they appear to have evaded their true destiny once again, and are apparently set to rally. Or are they? Well, as you will see, and as with the larger analysis provided above, again, it all depends on how you look at it.

What does the above statement mean? Well, in the first place it should be understood that in the sentiment game, if investors react to the news of the day by betting in bullish fashion, which for the purposes of our study would involve buying calls, contrary to one's first reaction in learning this, it should be realized the market in question actually possess a greater probability of declining, not rising. And as you may know, the study and implementation of investing strategies based on this condition is termed 'contrarian investing', a discipline core to our own investment style. Moreover, in today's highly speculative investment climate, where the term 'betting' is perhaps better used when describing the context of most 'investment' decisions these days, in my opinion contrary investing strategies are a necessity, not simply an alternative.

Back on topic now, and based on the understanding directly above then, it's important to know it's not the news itself but how investors react to news that will determine market direction, and after a prolonged period where one's logical sensibilities are brought into question repeatedly, most will change opinion with the only variable being how long it takes. In this respect, timing is a function of where the issue stands in one's greater hierarchy, along with personal tolerances of course, where because the stock market largely contributes to one's general sense of 'well being' if you are participating, meaning it's very important, its status will sit high in the order. What's more, because of this importance, resistance to change in attitude towards it will be that much greater given if one is betting on an outcome, a wrong decision could literally be 'life altering', and hence, potentially painful.

In continuing with this thought process, if one is continually conditioned by the powers that be to ignore reality on a previously understood factoid of lesser import, chances are he or she will change opinion more quickly in avoidance of pain, not to mention some form of sociologically oriented instant gratification may be attached to such behavior. As you move up the importance scale however, as with the stock market for example, despite the fact one is tempted to change his or her attitude in conformance to 'neo-con' oriented views of the day, which generally tend to look at the stark reality of a fundamentally decaying economy / market(s) in favorable fashion, on this issue not surprisingly change encounters a great deal resistance despite the same repeated attempts by 'opinion shapers' to put you in a box. That being said, after enough time and pain are endured though, here too both attitudes and / or behaviors will generally be altered as measured by the greater population.

Further to this, and in applying this understanding to how sentiment works in largely determining market direction then, it should be understood that despite desperate attempts by officialdom to get the entirety of the general population both believing and acting like good little neo-cons, a surprisingly large percentage of the population has tended to resist this manifestation, which has been borne out by the maintenance of surprisingly high open interest put / call ratios on US stock indices since the depths of despair back at the bottom(s) in late 2002, which was understandable, to more recent times, which could be viewed as surprising given both the economy and stock markets have largely regained traction and remain relatively stable. In this respect then, it's important to recognize the irony in this situation, along with perhaps a further irony developing into the future, one where once market participants finally believe the economy is looking better and they stop making bets on a negative outcome, systematically running put / call ratios down in the process, stocks will of course fall in tandem if history is a good guide. (See Figure 1)

Figure 1

As you can see above in looking at a 2-year plot of the S&P 500 (SPX) overlaid with its open interest put / call ratio included for comparison purposes, it could be argued this process is in fact now underway, given the new tendency of speculators to buy fewer puts these days could be more a function of economic exhaustion as opposed to the psychological variety in knowing the credit cycle is becoming increasingly stressed. What's more, some would argue once hedge funds get back into the seasonal swing of things and start leveraging up their portfolios again, they are bound to be buying more insurance (puts), which of course accounts for the put / call ratio on the SPX being higher in the first place as its the vehicle of choice for hedging purposes. Be that as it may, as it may not come to be, it would be difficult to notice the open interest put / call ratio for the SPX is still essentially at its lows while the index itself is only a minor rally away from recovery highs, creating a divergence of sorts. On this basis then, if put buying does not pick up soon, simply looking at the SPX, one should expect stocks to decline, especially if put / call ratios begin to vex new low territory for the move. Notice this would constitute a triple bottom breakdown of sorts, where one would be compelled to view this as a secular scale trend reversal, ushering in a likelihood the long awaited second leg down in the Primary Degree corrective sequence would be officially underway.

Now, in looking at the OEX plot one may be saying to yourself the above is a far too bearish assessment, one where based on the way hedgers and speculators are remaining more consistent with historical buying patterns one should expect the same for the SPX, and maybe they are right. But also, one must remember that the below plot of the open interest put / call ratio for the OEX includes long-term contracts (LEAPS) as well, and that when measuring shorter-term expressions of interest in isolation, the ratio (at .90) is well below parity, meaning market participants are actually quite bullish about the more near-term prospects of the stock market. (See Figure 2)

Figure 2

And the same can be said about Dow participants by and large, where once those who lost their heads on a recent put buying spree in long dated contracts of the DJX series have been completely squeezed out, which is in process right now as you can see below, prices should drop like a stone again. Further to this, it doesn't take much imagination to realize it was the squeezes in long dated contracts of the DJX series on the DOW and OEX that where the fuel for the fire in the most recent rally, and that once all the squeezing is done, which looks to be the case by the way, prices should fall again in tandem with these ratios. And they could fall hard this time, triggering the first correction in excess of 10-percent in the broad market since 2002. (See Figure 3)

Figure 3

You see unless things change very quickly here, we know participants are basically done shorting the market because of an absence in put buying in all the other options markets, where the contrast between activity in the DJX series (featured above) and the Dow Diamonds (DIA) (shown below) are at complete odds with one another on the same market, meaning the message being thrown off by one of the measures is wrong. Logically then, if participants in the other options markets are getting more bullish on balance for whatever reason, where in fact it could be buyer exhaustion as described above, one is compelled to conclude the message that was transmitted by DJX participants, one of panic the market was going to fall was wrong, as proven by prices of course. And again, as alluded to above in terms of explaining some of the ironies involved in ascribing cause to market direction, now that it appears bearish participants are exhausted, meaning they will not provide the fuel for future short squeezes as in the past, stocks are poised to fall in earnest, at least in theory. (See Figure 4)

Figure 4

We remain guarded in this regard because on top of it being a bit early to tell yet, where as explained above not only could hedgers still come back into the market this fall if their portfolios are leveraged up to do some insurance buying, we also have the risk of central banks going wild with liquidity again. With respect to both of these risks however, odds still remain in favor of the stock market bears in my opinion because with most monetary authorities around the world in tightening mode it's unlikely hedge funds will get increasingly aggressive until some sign a coordinated (global) easing is underway, where at present this is not the case. As mentioned last week in bringing this to your attention, monetary policy around the world is becoming increasing misaligned of late, where at present it appears the US needs a break on the tightening front, but because once the inflation (latent price increases) genie is out of the bottle, it's very hard to get it back under control, especially as this understanding pertains to the global nexus in play now.

And it won't take much past what's already happened to know stocks are in real trouble because just a few more percentage points of decline in the NASDAQ 100 (NDX) past the 18-percent it's already gone down in this most recent rout will put into the 'bear market' correction category once it goes over 20-percent. Based on the fact put / call ratios are coming down fast here, where less astute market players think the Fed actually still has control over its own monetary policy, and that they will pander these bozos, the probability of such an occurrence is running high in my books at present. (See Figure 5)

Figure 5

Oh, and let's not forget to take a look at how the little guy is betting on tech stocks via the cubes (QQQQ) these days, which was once the world's most popular ETF as measured by volume between 2000 and 2004 by the way. For reference purposes, you may find it interesting to know that when the NASDAQ was declining during this period put / call ratios were low, and remained that way until the beginning of 2003 when a confluence of speculators began 'selling the rallies' by purchasing puts as opposed to 'buying the dip', which would have involved ratio factors remaining low due to a propensity for participants to hold their positions overnight (and longer). This of course would have caused open interest ratios to remain on the lower side, along with index prices in the absence of adequate fuel to instigate meaningful short squeezes. (See Figure 6)

Figure 6

Based on the picture above, it's not difficult to envision a return to lower put / call ratios in the QQQQ based on the more recent topping action and new down trend (secular scale) possibly set to take hold with a breakdown from current support, a possibility that exists not only here, but with all of the measures featured above. And as you likely know by now after reading the entirety of this study then, such an advent would undoubtedly prove to be a negative for US stocks, a development that would also have a marked effect on global equities of all varieties as well.

Exactly how long put / call ratios would remain low if stocks, real estate values, and commodities begin to fall abruptly is a good question, as one would think the 'logical man' would be quick to revert back to a more bearish posture considering the importance of maintaining equities in terms most people's greater financial well being in today's asset driven economies. But then again, one could have made the same argument during the 2000 – 2002 meltdown, where to this day the vast majority of tech stock 'burn victims' have yet to re-enter this market, and have no intention of doing so if history is a good guide. So, on this basis then, one should not be surprised to see a majority of participants 'buying the dip' on weakness, meaning open interest put / call ratios could continue to decline, setting the stage for meaningful broad market weakness as process unfolds.

There are many pieces of the puzzle regarding the above that need to be filled in for those interested in possessing an informed take on things as process unfolds, where experience tells us only hard work will keep one ahead of the curve. In this regard, we invite you to visit our site and discover more about how an enlightened approach to market analysis and investing could potentially aid you in protecting your finances and family life into the future.

And of course if you have any questions or criticisms regarding the above, please feel free to drop us a line. We very much enjoy hearing from you on these matters.

Good investing all.

Special Note: All chart panels above were provided courtesy of Schaeffer Research.