Traders and commentators often use the phrase, “Dog days of August” to describe market action. Unfortunately, the general public seems to view this as a statement of late summer weakness, rather than as the low volume, stagnant, range trading action that it actually means. The S&P 500 has been in a 5% sideways trading range between2020 and 2120 since February. We’ll look at option, technical and seasonal analysis that could push this market to new highs and break the summer doldrums.
Beginning with option analysis we’ll look at both the Chicago Board Option Exchanges (CBOE) Index data as well as the September S&P futures options. The put/call ratio is a classic measure of investor sentiment. When the market owns more puts than calls, it is bearish and the ratio is greater than 1. When the market owns more calls than puts, it is bullish and the ratio is less than 1. It’s also important to know that stock index futures historically have more puts outstanding than calls because equity index put options are bought as insurance against a declining stock market. This is why the historical average of the put/call ratio is approximately 1.23. There have been 123 put options bought for every 100 call options.
Moving to the chart below, we’ve calculated this ratio back through November of 2006 using the CBOE’s data. The market has seen considerable volatility as noted by the several spikes above 2.0 through 2011. The market’s sideways period over the last few months has seen volatility collapse along with the put/call ratio. We’ve noted a couple recent collapses along with the where the S&P 500 was trading during those collapses. The September S&P 500 option skew shows a put/call ratio of .79 for strike prices within 10% of 2100. Each period of low volatility that saw a corresponding collapse in the put/call ratio was followed by a solid bull run.
Shifting gears to technical analysis brings me back to my pit trading days. I had breakfast every morning with a senior trader and market technician as I was absorbing all I could learn as a young trader. This was in the early 1990’s and due to the crash of 1987, I would later realize he had turned into a perma-bear. His most repeatable line was that, “Markets fail with wedge tops.” Feeling brave one morning I said, “Howard, I’ve been listening to this for three years and we’re nothing but higher. It seems to me that the longer we bounce along the top, the more likely we are to run through it, just like Newton’s first law.” I missed the crash of ’87 and made the bulk of my trading money on the buy side. It turns out, the art of technical analysis lies in the application, not the charting.
The daily S&P 500 futures chart below shows two supportive trend lines in blue and the wedge formation laid out in green. The support lines will converge around 2050 this December. Meanwhile, the wedge formation is bound on the high side by the double top at 2126.25 in the September futures. The distance from the low to high is 92.25 points. A close above the neckline and double top should put us on track for a run towards 2200, depending on the date of the breakout and slope.
Finishing with seasonal analysis provides a bit of qualitative feel good to our purely quantitative approach, thus far. The seasonal cycle of the S&P 500 has changed over the years and the chart below by Moore Research shows the 5, 15 and 30-year seasonal pattern of the September S&P 500 futures contract. The pattern is to buy the weakness early-mid August and hold through the September futures’ expiration. We’ve written extensively on the effects of expiration in the S&P 500 futures.
We believe the combination of the option values, technical formation and seasonal fuel could push this market through the double top, high of 2126.26 in the September contract and rally well into September, perhaps as high as 2220.
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