Monday, May 07, 2007

Early Warning Sign?

This market has been thin on warning signs, but an early one may have cropped up on Monday.

The TOF Ratio -- $COMPQ:$CPC -- registered an unusually hot reading on Monday,and closed above an important upper boundary. Option investors, convinced that the market's going up, swung hard to calls.

Whenever the option pit reaches this type of consensus, it's a signal that the current move may be nearing an end. The timing accuracy of this type of signal is very imprecise however. That's a big reason why technicians use indicators in combination. For the record, few other technical indicators - except ST overbought -- are suggesting any problems.

Today's print is just an early warning signal. The TOF Ratio doesn't trigger a Sell until the 21-day crosses back below the 50-day.

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Below is a 9-year view of the TOF Ratio which help puts the current peak in perspective. The last time the Ratio got this high was in Oct 2005. In that case, the market didn't top for another six months. Notice as well the famous irrational exuberance of the dotcom bubble in 1999. The TOF Ratio really over-ran its banks then, and may again some day.

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The TOF Ratio wasn't alone. Other timing indicators that use option data showed early warning signs as well on Monday. At VIX and More, Bill Luby noticed a similar pattern in the ISE Sentiment Index (ISEE). The ISEE uses opening long call and put positions to gauge investor sentiment. Like the TOF Ratio, extreme positions mark tops and bottoms. ISEE shot up on Monday as investors bought calls, but didn't print an extreme position.

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It's important to understand that the twitchy options data was about the only thing that was questionable about Monday's action. As the Dow took out an 80-year record, the NASDAQ pulled back on quiet trade. Composite volume fell 22% on just a 1 point pullback, a very positive sign.

Like the indexes themselves, the market internals were mixed: up on the NYSE and down on the NASDAQ. Still, New Highs outpaced New Lows 9-to-1 on both exchanges, a very strong ratio. Also, the IBD100 hit a new multi-year high on Monday, beating the broader market for the 4th straight day with a 0.5% gain. Even more important, a whopping 30 of 100 stocks printed record highs, a very strong number and up from Friday's 22 new highs.

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Another good sign is that Banks continued their recovery and hit a 10-week high on Monday. Yields have been slipping for 4 weeks as interest rate doves continue hopes for a 2007 Fed cut. It's possible that the current Bank strength is tied to this expectation, an expectation that many indicators suggest is wishful thinking.

Bank strength and yield weakness ahead of an FOMC meeting is a very optimistic combination. If the Fed stays inflation hawkish in this week's statement, the markets may express disappointment.

Below is the BKX and the 10-year Treasury yield. The horizontal green line on the BKX is the old all-time high.

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How you choose to react to Monday's TOF Ratio has a lot to do with the stocks you own and your tolerance for risk. It's a warning sign -- nothing more, nothing less.

Financial stocks and the bond market appear to have raised the stakes on the FOMC meeting. CSCO will be interesting tomorrow, but this week's real drama will be the pin action from Wednesday's Fed statement.

Have a great evening.




muckdog said...

TOF... A new one to me. This has been an incredible march against the wall of worry.

dk said...

TOF is short for "The Old Fool", a regular message board poster at the ^IXIC board at He publishes his Old Fool Notes most evenings, and has developed a loyal following.

I stumbled across him in 1999(?) over at Clearstation. In 1999, it was clever to divide the NASDAQ by the Put/Call Ratio and use it as a timing indicator. The 21-day/50-day crossovers are the Buy/Sell indicators. It's been very reliable over the years.