Call Option Activity May Be Flashing Caution Signal

It was a positive week last week, but in terms of dynamics, it was on odd one as well. That's a coy way of saying though the overt momentum was technically bullish, the market's undertow is getting a little squirrelly. We dissect all the sentiment oddities below, as well as take a bigger-picture look at the market's actual value.

Let's start from the top and work our way down, though, by beginning with the key economic data.

Economic Calendar

It was a light week last week in terms of economic data, but what little we got was good (and explains last week's progress for stocks). From first to last, consumer credit levels grew, unemployment claims dropped, and consumer sentiment improved.

Rather than contracting by the expected -$2.5 billion, credit usage grew by $3.4 billion; it looks like Americans are back to their old spending ways, which is actually good for companies.

Initial claims fell from 438K to 421K, and ongoing claims fell from 4.27 million to 4.08 million. Both numbers are now in decided downtrends.

And finally, the Michigan Sentiment Index for December pushed higher to 74.2, up from last month's 71.6. The upswing is the second big rise in a row, and unwinds an alarming pullback from July that had been lingering ever since.

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This week is clearly going to be much busier, kicking off today with the producer price inflation report; analysts are expecting a moderate lift. We'll also hear about November's retail sales today. They too should see moderate increases.

Consumer inflation will be unveiled tomorrow (Wednesday), and the rises on that front should be minimal (up 0.1% core, up 0.2% with everything). The current annual inflation rate is 1.2%.

Also on Wednesday we'll get two very important long-term data nuggets: Industrial production and capacity utilization. Both have been stagnant for a few months but are expected to have grown slightly in November.

On Friday, we'll get our next glimpse of the housing market's health by way of housing starts and building permits for last month. Both are expected to be higher, moving to 545K and 558K, respectively. Doing so would actually be quite amazing, considering the figures tend to sink from one month to the next this time of year (regardless of market conditions at that time). This may be a set-up for disappointment.

Surprised stocks have managed to make gains even though they were overbought in the short run? If so, you're not alone.

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The bullish news is that the SPX has undeniable momentum. The 15.69-point (+1.28%) gain last week for the S&P 500 not only pushed it up to a close of 1240.40, but also to new 52-week highs. Volume wasn't bad either. And, for the first time in many months, the major indices have closed above their upper Bollinger band.

All good news, right? Maybe…or maybe not. Were we to see this kind of action after a major low or in the shadow of a pullback, it would be bullish. To see it unfurl after the prior week's 2.9% gain, though —and the 16.5% gain we've seen since late August—there's just too much likelihood that the market's tank is out of gas.

The CBOE Volatility Index, or VIX, also suggests there's not a lot of “oomph” behind this latest bullish move. Why? Though the market's inched higher, the VIX hasn't actually made the commensurate move lower. Rather, the volatility index has paused at the familiar floor of its lower Bollinger band at 16.75.

If history is any clue, this is the point where the S&P 500's upper Bollinger band and the VIX's lower Bollinger band take a toll on the bulls and finally break the hot streak. But hey, the bulk of investors have to believe in that likelihood first, which they haven't yet. It's a real risk with high odds at this time though.

So, our MO from here is pretty clear: Be patient. One massive, high-volume rally (a blowoff top) or a decisive outside bearish reversal bar should jump start the impending pullback. (Yes, we know the two events are diametrical opposites.) Until we get a day with major volatility in either direction, though, the S&P 500 may well continue to take these baby steps higher.

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(Some) Sentiment Measures Suggest a Peak

One of BigTrends' core philosophies is a contrarian interpretation of investor sentiment data. In other words, we tend to bet against the crowd when the crowd is most certain it's right. As bizarre as it may sound, it works stunningly well.

One of the ways we can measure investor sentiment is by examining the number of (bearish) put options traded on any given day relative to the number of (bullish) call options. Well, a whole lotta calls were traded on Friday—at least on the ISE. In fact, the call/put ratio for the ISE—whether you're counting index and ETF options or just using equity (stock) options—was as low on Friday as it had been since April 15. If the date rings a bell, it may be because that was effectively the peak we saw before the big implosion in late April.

ISE Sentiment Index (Put/Call Ratio), VIX, and All-Market Put/Call Ratio:

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What's interesting—and a little odd—is that we didn't see the same extreme optimism and sharp move with the “total” put/call ratio, or the similar VIX. We saw glimmers of excessive bullishness on other fronts, but the ISE sentiment index is clearly the big red flag here.

We'll see how this all unfolds this week and look for other comparable hints. Even with just what we see here, though, this is a big problem for the bulls.

S&P 500 Valuation

Though we've dissected the daylights out of the market—and will continue to do so—it would be amiss to avoid talking about the root cause of the market's bigger trend. That root cause is earnings (and earnings growth). The broad market's P/E ratio is just as important though, and a little easier to work with.

Guys, scream all you want that the market is overvalued, but the reality is stocks are (legitimately) as undervalued as they've been in years. The trailing P/E of 14.85, and the rising P/E, is consistent with the earlier phases of bull markets. Earnings levels themselves are on the rise too, and even if they are so in part because corporations have cut costs to the bone, for investors, the effect is the same.

Though this won't affect the short-term ebb and flow that we tend to monitor each week, this still suggests the longer-term opportunity remains on the bullish side of the fence.

S&P 500 Monthly Chart with P/E Ratio:

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By Price Headley of BigTrends.com