Today I wanted to update my top 3 contrarian indicators. The market selloff continues and looking at contrarian indicators can give an investor an edge in determining the right time to buy. I introduced these indicators in this post; money flows; investors sentiment, and margin debt. Lets see what they’re telling us.
First up, money flows. Money continues to pour out of equity mutual funds. The latest data from ICI is below.
The $30B outflow out of equity funds in the week ending Aug 10th was the worst since Q1 2009. On a monthly basis you can see the comparison back to early 2007 in the following chart. This is a monthly chart as of the end of July. Once the Aug data makes it into the chart it will show a further deterioration, at least a $40B outflow for August.
The equity outflows have not reached the lows of late 2008 but they’re sure getting close. This could be a sign of a bottom forming in the equity market but as all indicators it’s not perfect and really needs to be confirmed by other indicators. Now lets look at investor sentiment.
The latest investor sentiment survey from AAII is below. The survey shows an uptick in investor bullishness which is not a sign of a bottom. Ideally you want to see extreme bearishness in the survey to indicate capitulation and a coming turn in the market.
Lastly, lets look at margin debt. Margin debt has started to roll over but is still at very high levels. See below. The problem is that this indicator is very late. The latest data is as of the end of June. Anecdotal data suggests the since the end of June margin calls have picked up significantly. In this Bloomberg article some of the brokers are saying margin debt is now at its lowest level in 2011. That would put it at 250K-275K in the chart below. That’s still above the levels in last summer’s correction.
In summary, these contrarian indicators are not yet signaling capitulation and a bottom in the market. I need to see bearish sentiment go up and for margin debt to come down. So, I guess I’d say the same I said in my last post on these indicators – I’m getting more bullish but the data says sit tight and keep watching. Also, the ultimate confirmation, the price action in the market, is just terrible and has not shown signs of a bottom. Yet. For long term investors there are definitely bargains in the market but the data suggests there may be even better opportunities to come.
5 Comments
donzidoug · August 19, 2011 at 4:07 pm
Thanks for writing about these again Paul. Your composed, and deliberate approach to investing is beginning to rub off. Although I continue making mistakes it’s obvious that the plan is improving and I know better results will follow. Again, thanks for all of your help and guidance. You may have no idea just how much you are helping one guy out here who’s really trying to hold it together in what seems like an almost insane investing climate.
libertatemamo · August 19, 2011 at 8:46 pm
Happy to help Doug. It is a pretty crazy environment right now.
Paul
J Carroll · August 20, 2011 at 7:49 am
Paul, how does this extreme negative volatility affect your options activity? If one is writing covered calls, one now owns stocks that are worth less than what he bought them for, and the net (option premiums minus S-T capital loss [if he sells]) is negative. If one wrote cash secured puts, one now owns stocks that he overpaid for and, again, the net (option premiums minus potential S-T capital loss) is negative. I see two ways to go from here; write covered calls and get the option premiums and accept the capital loss if the stocks sell for less than you paid for them, or just sit on your hands and wait for the market to rebound (which it has always done in the past). Would appreciate insight into your thought process during this stressful time. Heck, one definite benefit is less taxes to pay. Thanks.
libertatemamo · August 20, 2011 at 9:47 am
J, I like your optimistic attitude. Humor is definitely something to keep in this market, although hard to do. Reminds me of the saying, ‘If you can keep your head while others are losing their, you’ll be fine’ or something like that…Anyway, on to your question.
You’ve hit on one of the great challenges in option writing. And of course there is no easy answer. Let me address the first situation in where you wrote covered calls or cash secured puts before volatility went nuts. And in both cases you have stock that is worth less than even the discounted price the options gave you. So you have a mark to market loss on the position. This happened to me not too long ago so I’ll use that as an example, Sprint (S). I wrote some $5.00 cash secured puts when the stock was at $5.60 or so. My valuation of the stock is at least $6-$8. Then they report poor earnings and the stock goes to $4.50 in a day. The classic answer is well you ‘know’ the valuation is $5-$6 so you keep the stock and write some calls. Well, ok, but the stock went low enough that the premium on the $5.00 call wasn’t very good and I really didn’t want to sit on the stock. And most importantly, maybe my $5-$6 valuation is way wrong, maybe the market is right, or even if I’m right it will stay irrational longer than I can stay solvent. What to do? For me the answer is to set a loss point where I must admit that I’m wrong. For me in Sprint it was 15% below my acquisition price, or $4.25. When the stock hit that price I sold no matter what. Time to move on to another trade even if in the long term I’m right. For me the opportunity cost of tying up capital until the market realized I was right, best case, is just too big. Subsequently, the stock went below $3. But it could have gone right back up I still wouldn’t of regretted my decision. My options strategy is a trading strategy not a long term investment one. This case illustrates the challenge in option writing, the danger of the big blowup. You can write a ton of options and be right 9/10 times and make a few percent each time but that one loss can really take its toll. You must avoid that at all costs. Never let a small loss turn into a big one. No matter what. You gotta survive to play another day. I’ve modified my trading strategy a bit this year to deal with these cases. I will not take ownership of a stock when writing puts. I just set a loss point, usually twice the option premium I received, and if the option hits that price I take my loss and move on,
The other scenario is the one we’re in now where volatility has exploded and you’re looking to write options. On one hand this is what we’ve been waiting for, high premiums, but on the other they are high for a reason. I use the strategy I stated above, set a loss point for the option. Also, I would use a lower strike price. Go for the same percentage gain as when volatility was lower but now you can use a lower strike. This is a good way to reduce risk in these times.
But more recently I’m trying something new. It seems there is a volatility range where the premium is high but the market is not nuts, say a VIX of 25-35. But it seems that above 35 there is massive fear and the moves are just extreme and the premiums don’t seem to justify the volatility.. Maybe in these cases it worth just sitting it out or using other strategies. With this extreme volatility just going long stocks for a quick trade seems a lower risk approach. The week before last, I was able to pick up NLY below book value on one of those crazy days, and by the end of the week it was up 10%. I got out. If I’m going to use options in this environment I’m trying to enter positions when I get some price confirmation from the market that we’re in for at least at small bounce. This is a work in progress but I think it has potential.
Sorry for the book, maybe I just wrote another post……
Paul
J Carroll · August 21, 2011 at 7:55 am
Thanks for the reply, Paul. It is a crazy market right now and I have shied away from taking options positions that I am tied to, even for a month. The strategy you mentioned in your last paragraph, “just going long stocks for a quick trade,” is one I seem to have evolved (or maybe devolved) to; I view it as an options strategy where I am not obligated to sell at a set price over a set time (maybe long-term day trading or short-term swing trading is a better name for it). It has worked out good in a couple instances and not good in a couple. Look forward to the post this situation may inspire.
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